Pricing and Output Decisions:

Perfect Competition

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 Chapter 8 - Perfect Competition

• Four Basic Market Types

• Pricing and Output Decisions in Perfect Competition
Basic Business Decision
Key Assumptions
Total Revenue - Total Cost Approach
Marginal Revenue - Marginal Cost Approach
Economic Profit, Normal Profit, Loss, and Shutdown
The Short Run and Long Run

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 Four Basic Market Types

•Perfect Competition
•Monopoly
•Monopolistic Competition
•Oligopoly

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 Fig 8.1a - Four Basic Market Types

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 Key Assumptions : Perfect Competition

Perfect Competition

• Price taker
• Distinction between short run and long run
• Objective is to maximize profit or minimize loss in
the short run
• Opportunity cost is included in decision making

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 Review of Costs

Review of terminology
• Economic cost includes explicit costs and
opportunity costs
• Normal profit occurs when revenue just covers
all of the firm’s economic cost
• Economic loss occurs when revenue fails to
cover the firm’s economic cost
• Economic profit occurs when revenue more
than covers the firm’s (total) economic cost
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 Perfect Competition
• The Demand Curve Facing the Firm

– Since the firm is a price taker,

the price to the firm for each
unit remains the same no
matter how much the firm sells
– Perfectly Elastic since
consumers are willing to buy
as much as the firm is willing
to sell at the going market price
– Horizontal at the market price

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 Key Assumptions : Demand Curve

• Marginal Revenue and Average Revenue

– Since the firm receives the
market price for each unit
sold, and this market price
does not change, the firm’s
marginal revenue (MR) and
average revenue (AR) curves
are also horizontal at the
market price.

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 Key Assumptions : Total Revenue

• Marginal Revenue
– Marginal revenue tells us how tot
al revenue changes as we sell an
additional unit.
– Marginal revenue represents
the slope of the total revenue cur
ve.
– Since MR is positive and
constant, the total revenue
(TR) curve is increasing at a
constant rate.

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 Selecting the Optimal Output Level TR-TC

• Graphically, find the output

level that maximizes the
distance between the total
revenue curve and the
total cost curve.

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 Selecting the Optimal Output Level MR=MC

• Marginal revenue is the revenue the firm receives

from selling an additional unit.

• Marginal cost is the cost the firm incurs by

producing an additional unit.

• If marginal revenue exceeds marginal cost it is

worthwhile for the firm to produce and sell an
additional unit.

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 Selecting the Optimal Output Level MR=MC

MR=MC Rule

• 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.
• Applies to any firm that wishes to maximize
profit.
• For the perfectly competitive firm, the rule may
be restated, P=MC.

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 Profit Maximization for the competitive Firm
W hat Q maximizes the firm’s profit?
If increase Q by one unit, revenue rises by MR, cost rises by MC. Profit-maximizing
quantity can be found by comparing marginal revenue MR and marginal cost MC.

If MR > MC, then increase Q to raise profit. As long as marginal revenue exceeds
marginal cost, increasing output will raise profit.

If MR < MC, then reduce Q to raise profit. If marginal revenue is less than
marginal cost, the firm can increase profit by decreasing output.

If MR = MC, Maximum profit. Profit-maximization occurs where marginal revenue is

equal to marginal cost.

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 Profit Maximization : Perfect Competitive
The firm maximizes profit by producing the optimal
quantity Q* at where marginal cost equals marginal revenue.
Costs
and
Revenue
MC

P2
ATC

P1 P 1= AR 1= M R1
AVC

P3

0 Q1 QMAX Q2 Quantity

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 Example : Optimal Output Level MR=MC

Example :

• Graphically, find the out

put at which MR=MC.
Label this Q*
• Profit ?

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 Example : Optimal Output Level MR=MC

Example :
• Graphically, find the out
put at which MR=MC.
Label this Q*
• Profit=TR – TC
=(Q* x P) – (Q* x AC)
=Q*(P - AC)
=Rectangle DABC

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 Example : Profit Maximization
Example : Pricing and output decisions in perfect competition
Case A: Economic Profit
What is the Optimization Rule for
output (Q*) ?
What is the firm’s Profit ?
What is the Breakeven Price ?

When do Firms Shutdown ?

and/or At what Price?
Is this a short run or long-run decision?

The firm’s SR supply curve is the portio

n of its MC curve above AVC.

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 Example 5 Cont’d/- : Profit Maximization

Pricing and output decisions in perfect competition

• Case B: Economic Loss

When doesthe firm incurs a loss?

At optimum output,
price is above/below AC or AVC ?
 what level of output would the firm be
better off producing in the short run?
What would be the firm’s decision in th
e long run?

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 The Competitive Firm’s Long run Supply Curve

The firm’s Long Run

Costs
LR supply curve is
MC
the portion of
its MC curve above LRATC
LRATC.

Q
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 Supply Curve – Shutdown vs Exit

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  shifts the supply curve to the
right  puts downward pressure on price and reduces profits
– economic loss causes exit of firms  shifts the supply curve to the
left  puts upward pressure on price and increases profits

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 Chapter Example : Two Panel Diagram – Firm and Market

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 Appendix 8A - Calculus
Appendix – Pricing and Output Decisions – Perfect Competition

Example :

Assume market price is $ 25

Determine whether the firm is earning a profit or loss?

How will you express the profit or loss equation?
Calculate the optimal level of output at market price.

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 Appendix : Calculus - Example 1 - Perfect Competition

Example 1 : Cost Function of a Perfectly Comp Firm : C (Q) = 5 + Q2.

where market price is $ 20.

a. What price should the firm set for the product?

b. What level of output should be produced to maximize profit?
c. How much profit does the firm expect to earn?

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 Appendix : Calculus - Example 2 - Perfect Competition

Example 2 : Cost Function of a Perfectly Comp Firm : C (Q) = 100 + Q2

where market price is $10.

Given FC of $100 & VC of Q2

a. What is the level of Optimal Output?

b. What will be the profit or loss if firm makes the optimal decision?

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 References

Book:
Managerial Economics, 7th Edition, Keat, Young, Erfle

Chapter 8 – 1. Perfect Competition

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Book:
Managerial Economics, 7th Edition, Keat, Young, Erfle

Next : Chapter 8 - 2. Monopoly

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