Price Output Decisions

Price Output Decisions : 

Price Output Decisions

Perfect Competition : 

Perfect Competition One extreme of the market structure spectrum Characteristics: Large number of firms Products are homogenous (identical) – consumer has no reason to express a preference for any firm Freedom of entry and exit into and out of the industry Firms are price takers – have no control over the price they charge for their product Each producer supplies a very small proportion of total industry output Consumers and producers have perfect knowledge about the market

Slide 3: 

Perfect Competition Diagrammatic representation Cost/Revenue Output/Sales P = MR = AR MC AC Q1 Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method). What would happen? AC1 MC1 AC1 Abnormal profit Q2 Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again. P1 = MR1 = AR1 The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area. Average and Marginal costs could be expected to be lower but price, in the short run, remains the same.

Perfect Competition : 

Perfect Competition Diagrammatic representation Cost/Revenue Output/Sales The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR P = MR = AR MC The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises. AC The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values. Q1 Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply. At this output the firm is making normal profit. This is a long run equilibrium position.

Monopolistic or Imperfect Competition : 

Monopolistic or Imperfect Competition Characteristics: Large number of firms in the industry May have some element of control over price due to the fact that they are able to differentiate their product in some way from their rivals – products are therefore close, but not perfect, substitutes Entry and exit from the industry is relatively easy – few barriers to entry and exit Consumer and producer knowledge imperfect

Monopolistic or Imperfect Competition : 

Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue Output / Sales MC AC Marginal Cost and Average Cost will be the same shape. However, because the products are differentiated in some way, the firm will only be able to sell extra output by lowering price. D (AR) The demand curve facing the firm will be downward sloping and represents the AR earned from sales. MR Since the additional revenue received from each unit sold falls, the MR curve lies under the AR curve. We assume that the firm produces where MR = MC (profit maximising output). At this output level, AR>AC and the firm makes abnormal profit (the grey shaded area). Q1 £1.00 £0.60 Abnormal Profit If the firm produces Q1 and sells each unit for £1.00 on average with the cost (on average) for each unit being 60p, the firm will make 40p x Q1 in abnormal profit. This is a short run equilibrium position for a firm in a monopolistic market structure.

Slide 7: 

Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue Output / Sales MC AC D (AR) MR Q1 Because there is relative freedom of entry and exit into the market, new firms will enter encouraged by the existence of abnormal profits. New entrants will increase supply causing price to fall. As price falls, the AR and MR curves shift inwards as revenue from each sale is now less. AR1 MR1

Slide 8: 

Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue Output / Sales MC AC D (AR) MR Q1 AR1 MR1 Notice that the existence of more substitutes makes the new AR (D) curve more price elastic. The firm reduces output to a point where MC = MR (Q2). At this output AR = AC and the firm will make normal profit. Q2 AR = AC

Slide 9: 

Monopolistic or Imperfect Competition Implications for the diagram: Cost/Revenue Output / Sales MC AC AR1 MR1 This is the long run equilibrium position of a firm in monopolistic competition. Q2 AR = AC

Monopoly : 

Monopoly Monopoly power – refers to cases where firms influence the market in some way through their behaviour – determined by the degree of concentration in the industry Influencing prices Influencing output Erecting barriers to entry Pricing strategies to prevent or stifle competition May not pursue profit maximisation – encourages unwanted entrants to the market Sometimes seen as a case of market failure

Monopoly : 

Monopoly Costs / Revenue Output / Sales AC MC AR MR AR (D) curve for a monopolist likely to be relatively price inelastic. Output assumed to be at profit maximising output (note caution here – not all monopolists may aim for profit maximisation!) Q1 £7.00 £3.00 Monopoly Profit Given the barriers to entry, the monopolist will be able to exploit abnormal profits in the long run as entry to the market is restricted. This is both the short run and long run equilibrium position for a monopoly

Slide 12: 

Monopoly Costs / Revenue Output / Sales AC MC AR MR Welfare implications of monopolies A look back at the diagram for perfect competition will reveal that in equilibrium, price will be equal to the MC of production. We can look therefore at a comparison of the differences between price and output in a competitive situation compared to a monopoly. Q1 £3 The price in a competitive market would be £3 with output levels at Q1. Q2 £7 The monopoly price would be £7 per unit with output levels lower at Q2. On the face of it, consumers face higher prices and less choice in monopoly conditions compared to more competitive environments. Loss of consumersurplus The higher price and lower output means that consumer surplus is reduced, indicated by the grey shaded area.

Slide 13: 

Monopoly Costs / Revenue Output / Sales AC MC AR MR Welfare implications of monopolies Q1 £3 Q2 £7 The monopolist will be affected by a loss of producer surplus shown by the grey triangle but…….. The monopolist will benefit from additional producer surplus equal to the grey shaded rectangle. Gain in producer surplus

Slide 14: 

Monopoly Costs / Revenue Output / Sales AC MC AR MR Welfare implications of monopolies Q1 £3 Q2 £7 The value of the grey shaded triangle represents the total welfare loss to society – sometimes referred to as the ‘deadweight welfare loss’.

Oligopoly : 

Oligopoly Features of an oligopolistic market structure: Price may be relatively stable across the industry – kinked demand curve? Potential for collusion Behaviour of firms affected by what they believe their rivals might do – interdependence of firms Goods could be homogenous or highly differentiated Branding and brand loyalty may be a potent source of competitive advantage Non-price competition may be prevalent Game theory can be used to explain some behaviour AC curve may be saucer shaped – minimum efficient scale could occur over large range of output High barriers to entry

Oligopoly : 

Oligopoly The kinked demand curve - an explanation for price stability? Price Quantity D = elastic D = Inelastic £5 100 Kinked D Curve The principle of the kinked demand curve rests on the principle that: If a firm raises its price, its rivals will not follow suit If a firm lowers its price, its rivals will all do the same Assume the firm is charging a price of £5 and producing an output of 100. If it chose to raise price above £5, its rivals would not follow suit and the firm effectively faces an elastic demand curve for its product (consumers would buy from the cheaper rivals). The % change in demand would be greater than the % change in price and TR would fall. Total Revenue A Total Revenue B If the firm seeks to lower its price to gain a competitive advantage, its rivals will follow suit. Any gains it makes will quickly be lost and the % change in demand will be smaller than the % reduction in price – total revenue would again fall as the firm now faces a relatively inelastic demand curve. Total Revenue B Total Revenue A The firm therefore, effectively faces a ‘kinked demand curve’ forcing it to maintain a stable or rigid pricing structure. Oligopolistic firms may overcome this by engaging in non-price competition.