Name: Karina Permata Sari (29115447)

Program: GM 2

Business Economics Summary

Pricing Decision
Introduction
The pricing and output decision will actually be answered within the framework of four basic
types of markets: perfect competition, monopoly, monopolistic competition, and oligopoly.
Perfect competition and monopoly can be considered the two extreme market environments in
which a firm competes in terms of market power. In terms of market power, monopolistic
competition and oligopoly are somewhere between the two extremes of perfect competition and
monopoly. From a pedagogical standpoint, it is easier to understand and appreciate the
particulars of monopolistic competition and oligopoly if there is first a thorough understanding
of perfect competition and monopoly.

Competition and Market Types in Economic Analysis

The Meaning of Competition

In economic analysis, the most important indicator of the degree of competition is the ability
of firms to control the price and use it as a competitive weapon. The extreme form of
competition is "perfect" competition. In this market, the competition is so intense and the
firms are so evenly divided that no one seller or group of sellers can exercise any control over
the price. That is, they are all price takers. A second key measure of competition in economic
analysis is the ability of a firm to earn an above normal or economic profit in the long
run.

Figure 1 Comparison of Four Market Types by Characteristics Affecting

Degree of Competition

The figure 1 above shows the four market types according to the degree of competition as
indicated by the extent of market power and the ability of firms to earn long-run economic
profit. A firm in monopolistic competition may have some market power because its product
can be differentiated from those sold by its competitors. A firm operating in an oligopoly
derives its market power from its ability to differentiate its product, its relatively large size, or
both.

Figure 2 The Four Basic Market Types

Pricing and Output Decisions in Perfect Competition

The Basic Business Decision

Imagine a firm that is considering entry into a market that is perfectly competitive. If it
decides to compete in this market, it will have no control over the price of the product.
Therefore, the firm's managers must make a business case for entering this market on the basis
of the following questions:
1. How much should we produce?
2. If we produce such an amount, how much profit will we earn?
3. 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?
The perfectly competitive firm must operate in a market in which it has no control over the
selling price, there may be times when the price does not fully cover the unit cost of
production (i.e., average cost). Thus, a firm must assess the extent of its losses in relation to

the alternative of discontinuing production. In the long run, a firm that continues to incur
losses must eventually leave the market. But in the short run, it may be economically
justifiable to remain in the market, with the expectation of better times ahead. This is because
in the short run certain costs must be borne regardless of whether the firm operates. These
fixed costs must be weighed against the losses incurred by remaining in business. It is
reasonable to expect that a firm will remain in business if its losses are less than its fixed
costs-at least in the short run.

Key Assumptions of the Perfectly Competitive Market

The key assumptions in analyzing the firms output decision in perfect competition are:
1. The firm operates in a perfectly competitive market and therefore is a price taker.
2. The firm makes the distinction between the short run and the long run.
3. The firm's objective is to maximize is profit in the short run. If it cannot earn a profit, then
it seeks to minimize its loss.
4. The firm includes its opportunity cost of operating in a particular market as part of its total
cost of production
For the economic analysis of a firm's output and pricing decisions to have a unique solution,
the firm must establish a single, clear-cut objective. This objective is the maximization of
profit in the short run. If the firm has other objectives, such as the maximization of revenue in
the short run, the output that it would select would differ from the one based on this model.
The consideration of opportunity cost in the cost structure of the firm is vital to this decisionmaking model. The firm must check whether the going market price enables it to earn a
revenue that covers not only its out-of-pocket costs, but also the costs incurred by forgoing
alternative activities.

The Total Revenue-Total Cost Approach to Selecting the Optimal Output Level
The most logical approach to selecting the optimal level of output is to compare the total
revenue with the total cost schedules and find that level
of output that either maximizes the firm's profit or
minimizes its loss. Graphically, this output level can be
seen as the one that maximizes the distance between the
total revenue curve and the total cost curve. By
convention, this point has been labeled Q*

Figure 3 Determining Optimal Output from Cost and

Revenue Curves---Perfect Competition

The Marginal Revenue-Marginal Cost Approach to Finding the Optimal Output Level
Marginal analysis is at the heart of the economic analysis of the firm. The marginal revenue
and marginal cost columns contain the key numbers the firm must use to decide on its optimal
level of output. Using the relationship between marginal revenue and marginal cost to decide

on the optimal level of output is referred to in economics as the MR = MC rule. The rule is
stated as follows:
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.
The MR = MC rule applies to less any firm that wants to maximize its profit, regardless of
whether it has the power to set the price. However, in the particular case in which the firm has
no power to set the price (i.e., it is a price taker), the MR = MC rule can be restated as the P =
MC rule. This is simply because when a firm is a price taker, its marginal revenue is in fact
the going market price. Although the optimal output level can be found just as easily by using
the
TR - TC approach, economists rely much more on the MR - MC approach in analyzing the
firm's output decision.

The Competitive Market in the Long Run

Regardless of whether the market price in the short run results in economic profit, normal
profit, or a loss for competing firms, economic theory states that in the long run, the market
price will settle at the point where these firms earn a normal profit. This is because over a long
period of time, prices that enable firms to earn above normal profit would induce other firms
to enter the market, and prices below the normal level would cause firms to leave the market.
Figure 4a shows a hypothetical short-run situation in which the price (determined by supply
and demand) is high enough to enable a typical firm competing in this market to earn
economic profit. (Viewed in another way, given the market price, the firm's cost structure is
low enough to enable it to earn economic profit.) Over time, new firms would enter the
market, and the original firms would expand their fixed capacity in response to the incentive
of economic profit. This would have the effect of increasing the market supply (shifting the
supply curve to the right) and reducing the market price. At the point where firms earn only
normal profit, this adjustment process would cease. Figure 4b shows the opposite case, in
which a short-run loss incurred by firms in the market causes firms in the long run to leave the
market. This causes price to rise toward the level in which the remaining firms would earn a
normal profit. An understanding of the conditions motivating market entry or exit over the
long run should lead the firms to consider the following points:
1. The earlier the firm enters a market, the better its chances of earning above-normal profit
(assuming a strong demand in this market).
2. 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.
3. Firms that find themselves unable to compete on the basis of cost might want to try
competing on the basis of product differentiation instead, although this is extremely
difficult in this type of market.

Figure 4 Long-Run Effect of Firm's Entering and Exiting Market

Pricing and Output Decisions in Monopoly Markets

A monopoly market consists of one firm. The firm is the market. The key point is that a
monopoly firm's ability to set its price is limited by the demand curve for its product and, in
particular, the price elasticity of demand for its product. The price elasticity of demand indicates
how
much
more
or less people are willing to buy in relation to price decreases or increases. If we assume the
firm's downward-sloping demand curve is linear, we know that as the price of the product falls,
the marginal revenue from the sale of additional units falls, reaches zero, and then becomes
negative. The ability of a monopoly to set its price is further limited by the possibility of rising
marginal costs of production. If this is the case, then surely at some point the increasing cost of
producing additional units of output will exceed the decreasing marginal revenue received from
the sale of additional units. In conclusion, the firm that exercises a monopoly power over its
price should not set its price at the highest possible level. Instead, it should set it at the right
level. And what is this 'right" level? It is the level that results in MR = MC.

The Implications of Perfect Competition and Monopoly for Managerial

Decision Making
In the case of perfect competition, the market price is determined for the managers by the forces
of supply and demand. All that they have to do is to decide whether their cost structure will
enable their firm to at least earn a normal amount of profit. In the case of monopoly, the fact that
the firm has no competition enables its managers simply to follow the MR = MC rule to
maximize its profit. The most important lesson that managers can learn by studying the perfectly
competitive market is that it is extremely difficult to make money in a highly competitive
market. Indeed, the only way for firms to survive in perfect competition is to be as cost efficient
as possible because there is absolutely no way to control the price. Another lesson offered by the
perfectly competitive model is that it might pay for a firm to move into a market before others
start
to
enter.
This
might
mean
entering a market even before the demand is high enough to support an above-normal price.
Spotting these market opportunities and taking the risk of going into
these markets are key tasks of a good manager. Of course, the demand may never materialize or
the long-run increase in supply might be so great that no one makes any money in this market.
But that is all part of the risk that a manager must sometimes take. The key lesson for managers
to learn from the many examples of once-powerful monopolies or near-monopolies that have
eventually been affected by changing economics is not to be complacent or arrogant and assume
their ability to earn economic profit can never be diminished.