CHAPTER 8 Price
interaction of buyers and seller in the
MANAGING IN
COMPETITIVE,
MONOPOLISTIC, AND
MONOPOLISTICALLY
COMPETITIVE MARKETS
Perfectly Competitive Market – a
market in which (1) there are many
buyers and sellers; (2) each firm
produces a homogenous product; (3)
buyers and sellers have perfect
information; (4) there are no
transaction costs; and (5) there is
free entry and exit.
No single firm can influence the price
of the product.
There are many small firms, each
selling an identical product means
that the consumers view the products
as perfect substitutes.
All firms charge the same price for
the good and this price is determined
through the interaction of all buyers
and sellers in the market.
Additional firms can enter
market if economic profits
earned and firms can leave the
market if they are sustaining losses.
Example of perfectly competitive
market – agriculture, market of
several types of computer hardware
DEMAND AT THE MARKET AND
FIRM LEVELS
is determined by the
market
Price is determined by the
intersection of the market supply and
demand curves
Firm demand curve – the demand
curve for an individual firm’s product;
in a perfectly competitive market, it
is simply the market price.
Demand curve of a firm – horizontal
line because the firm can sell as much
as it wishes at the equilibrium price.
Demand curve of the market -
equilibrium price is determined by
the intersection of demand and
supply.
Perfectly elastic – the demand curve
for individual perfectly competitive
firm.
SHORT-RUN OUTPUR
DECISIONS
Short run – is the period of time
where some fixed factors of
production exist.
the
are
MAXIMIZING PROFITS
The demand for an individual firm’s
product is the market price of the
output which we denote P
P = demand/market price
Q = output of the firm Profit maximizing output – is the
output at which marginal revenue
R (total revenue) = R = PQ
equals marginal cost.
There is a linear relationship between
P R I N C I P L E~
revenues and output of the firm.
Competitive output rule – to
Marginal Revenue – the change in
maximize profits, a perfectly
revenue attributes to the last unit of
competitive firm produces the output
output; for a competitive firm, MR is
at which price equals marginal cost in
the market price; it is the slope of
the range over which marginal cost is
the revenue curve.
increasing.
A calculus alternative
P = MC (Q)
𝑑𝑅
𝑀𝑅 = 𝑑𝑄
Demonstration problem
P R I N C I P L E~ Cost function: C(Q) = 5 + 𝑄 2
Competitive Firm’s Demand 𝐶(𝑄) = 𝑓 + 𝑎𝑄 + 𝑏𝑄 2 + 𝑐𝑄 3

The demand curve for a competitive 𝑀𝐶(𝑄) = 𝑎 + 2𝑏𝑄 + 3𝑐𝑄 2

firm’s product is a horizontal line at a=0
the market price. This price is the
competitive firm’s marginal revenue. b=1

𝐷 𝑓 = 𝑃 = 𝑀𝑅 c=0

A calculus alternative MC = 2Q

For a perfectly competitive firm: Equating with price:

R = PQ 20 = 2Q = 10

𝑑𝑅 Profit = P(Q) – C(Q)

𝑀𝑅 = =𝑃
𝑑𝑄
=( 20 x 10 ) – (5 + 102 )
The profits of a perfectly
=200 – 5 + 100
competitive firm is simply: Revenue
minus Cost =200 – 105

Profit – vertical distance between =$95

the cost function and the revenue
MINIMIZING LOSSES
line.
Short-run operating losses – when
the loss is less than the loss that
would result if the firm completely
shut down its operation.
When the market price, lies below
the average total cost curve but
above the average variable cost
curve, the firm produces output
where MC = market price.
The decision to shut down – when
the cost shutting down the firm’s
operation is less than the cost of
producing Q* units.
When the market price, lies below
the average variable cost curve,
there will be losses for every output
produced.
Fixed cost = [ATC(Q*)-AVC(Q*)]Q*
P R I N C I P L E~
Short-run output decision under
perfect competition
To maximize short-run profits, a
perfectly competitive firm should
produce in the range of increasing
marginal cost where P = MC, provided
that P≥AVC. If P<AVC, the firm
should shut down its plant to minimize
its losses.
Demonstration problem:
C(Q) = 100 + 𝑄 2
$10 – market price
Fixed cost = $100
Variable cost = 𝑄 2
MC = 2Q
Equate to price
10 = 2Q
Q=5
C(Q) = 100 + 52
= $75
AVC = 25/5
AVC = 5
Since price is greater than average
variable cost, the firm should
produce 5 units in the short run.
Profit = P(Q) – TC(Q)
= 10(5) – ( 100 + 52 )
= 50 – 125 = -$75 - loss
Should not shut down its operation
because $100 fixed cost is greater
than $75 loss of operating the firm.
THE SHORT-RUN FIRM AND
INDUSTRY SUPPLY CURVES
P R I N C I P L E~
The firm’s short-run supply curve
The short-run supply curve for a
perfectly competitive firm is its
marginal cost curve above the
minimum point on the AVC curve.
Industry supply curve is flatter than
the supply curve of an individual firm.
The more firms in the industry, the
farther to the right is the market
supply curve.
LONG RUN DECISIONS
As more firms enter the industry,
the industry supply curves shift to
the right -> lowers the equilibrium
market price –> shifts down the
demand curve for an individual firm’s
product –> lowers it profits.
As firms exit the industry, the
market supply curve shifts to the left
-> increasing the market price ->
shifts up the demand curve for an
individual firm’s product -> increases
the profits of the remaining firms in
the industry.
P R I N C I P L E~
Long-run competitive equilibrium
In the long run, perfectly competitive
firms produce a level of output such
that
1. PC = MC
2. P = minimum of AC
Important welfare implications of
the long run properties of perfectly
competitive market.
1. Market price is equal to the
marginal cost of production.
2. Long run competitive
equilibrium is that price equals
the minimum point on the
average cost curve.
MONOPOLY
Monopoly - a market structure in
which a single firm serves an entire
market for a good that has no close
substitutes.
Monopoly power
Since all consumers in the market
demand the good from the
monopolist, the market demand curve
and the demand for the firm’s
product is the same.
The monopolist is free to charge any
price of the product in the absence
of legal restrictions. But that doesn’t
mean that the monopolist can sell as
much as they want because the
decision of how much to purchase is
within the consumers.
Sources of monopoly power
Four primary sources of monopoly
power: ( this creates a barrier that
can prevent other firms in entering
the market)
1. Economies of Scale
Exhist whenever LRAC decline
as output increases; can lead to
a situation where a single firm
services the entire market for
a good.
2. Economies of Scope
Exist whenever LRAC increase
as output increases; exist when
the total cost of producing
two products within the same
firm is lower than when the
products are produced by
separate firms; can lead to
monopoly power
3. Cost Coplimentary
 Exist when the marginal cost inventor (kasi di na sya
of producing one output is magtatry try)
reduced when the output of
Maximizing profits
another product is increased.
Example: production of donuts Marginal revenue
and donut holes; multiproduct Linear demand curve is elastic at high
firms that enjoy cost prices and inelastic at low prices.
complimentaries have less
marginal cost than firms As output is increased above 0,
producing a single product; can demand is elastic and the increase in
lead to monopoly power ouput (wc implies a lower price) leads
4. Patents and Other Legal to an increase in total revenue.
Barriers 1+𝐸
𝑀𝑅 = 𝑃[ ]
The government can grant an 𝐸
individual or a firm a monopoly Demonstration problem:
right.
E = -2
For example (1) a city may
prevent another utility 1−2 −1
𝑀𝑅 = 𝑃 [ ]= 𝑃
company from competing −2 −2
against the local utility E = -1
company (2) potential monopoly
1−1
power generated by the Patent 𝑀𝑅 = 𝑃 [ ]=0
−1
system- gives the inventor of a
Ee = -0.5
new product the exclusive
right to sell the product for a 1 − 0.5 0.5
𝑀𝑅 = 𝑃 [ ]= 𝑃 = −𝑃
given period of time. −0.5 −0.5
Rationale behind granting Inverse demand function
monopoly power to a new
-indicates the price per unit as a
inventor is based on the ff
function of the firm’s output.
arguments:
Inventions take many years Linear inverse demand function
and cosiderable sums of money
P(Q) = a + bQ
to develop. And when the
product is introduced to public, Where a is a number greater than 0
other firms may produce the &
same product in the absence of
patent. The new producer will b is a number less than 0
incur more profits than the Mr for linear inverse demand
 𝑀𝑅 = 𝑎 + 2𝑏𝑄 Marginal cost of producing in plant 1
Demonstration problem is

𝑀𝐶1 = 3𝑄1
P = 10 – 2Q
Marginal cost of producing in plant 2
Q=3
is
P = 10 – 2(3)
𝑀𝐶2 = 𝑄2
P=4

𝑀𝑅 = 10 + [2(2)(3)] = −2 𝑀𝑅(𝑄) = 𝑀𝐶1 (𝑄1 )

The output decision 𝑀𝑅 (𝑄) = 𝑀𝐶2 (𝑄2)

PRINCIPLE~

Monopoly Output Rule 𝑀𝑅(𝑄) = 70 − 𝑄

70 − (𝑄1 + 𝑄2 ) = 3𝑄1
A profit-maximizing monopolist
shoud produce the output 𝑄 𝑀 such 70 − (𝑄1 + 𝑄2 ) = 𝑄2
that marginal revenue equals marginal
cost:
𝑄2 = 70 − 4𝑄1
𝑀𝑅(𝑄 𝑀 ) = 𝑀𝐶(𝑄 𝑀 )
Substitute to the second equation
PRINCIPLE~
70 − (𝑄1 + 70 − 4𝑄1 ) = 𝑄2
Multiplant Output Rule
𝑄1 = 10
Let MR(Q) be the marginal revenue
Substitute to the first equation
of producing a total of 𝑄 = 𝑄1 + 𝑄2
units of ouput. Suppose the marginal 70 − (10 + 𝑄2 ) = 3(10)
cost of producing 𝑄1 units of ouput in 𝑄2 = 30
plant 1 is 𝑀𝐶1 (𝑄1 ) and that of
The frim should produce 10 units in
producing 𝑄2 units in plant 2 is
plant 1 and 30 units in plant 2 for a
𝑀𝐶2 (𝑄2 ). The profit maximization
total output of Q = 40 units.
rule for the two-plant monopolist is
to allocate output among the two Inverse demand function:
plants such that P = 70 - .5(40) = 50
𝑀𝑅(𝑄) = 𝑀𝐶1 (𝑄1 )
IMPLICATIONS OF ENTRY
𝑀𝑅 (𝑄) = 𝑀𝐶2 (𝑄2) BARRIERS

Demonstratio problem: If a monopolist is earning positive

economic profits, the presence of
P(Q) = 70 - .5Q
barriers to entry prevents other
firms from entering thr market to
reap a portion of those profits.

In monopoly, price exceeds the

marginal cost of production: 𝑃𝑀 > 𝑀𝐶

The price in the market reflects the

value to society of another unit of
output.

Marginal cost reflects the cost to

society of the resources needed to
produce an additional unit of output.

Since price exceeds Marginal cost,

the monopolists produces less output
than is socially desirable.

In effect, society would be willing to

pay more for one more unit of output
than it would cost to produce the
unit.