I write a summary of market structure and how it affects the pricing and output decision based on Keat, P., and Phillip Young. 2008. Managerial Economics, 6th edition. Pearson (KY) e-book. The firm needs to establish its price and output levels to achieve its business objective of profit maximization. The pricing and output decision can be decided by considering the framework of basic types of market :
- Perfect competition (no market power)
- A large number of relatively small buyers and sellers
- Standardized product
- Very easy market entry and exit
- Nonprice competition not possible.
2. Monopoly (absolute market power subject to government regulation)
- One firm, firm is the industry
- Unique product or no close substitutes
- Market entry and exit difficult or legally impossible
- Nonprice competition not necessary
3. Monopolistic competition (market power based on product differentiation)
- A large number of relatively small firms acting independently
- Differentiated product
- Market entry and exit relatively easy
- Nonprice competition very important
4. Oligopoly (market power based on product differentiation and/or firm’s dominance of the market)
- A small number of mutually interdependent and relatively large firms
- Differentiated or standardized product
- Market entry and exit difficult
- Nonprice competition very important among firms selling differentiated products
In perfect competition, there are so many sellers offering the same product that an individual firm has virtually no control over the price of its product. The interaction of supply and demand decides the price for all participants in this type of market structure. The degree of competition in the market is the ability of firms to control the price and use it as a competitive weapon.
PRICING AND OUTPUT DECISIONS IN PERFECT COMPETITION
The firm should consider the basic question due to no control over the price of the product to enter the perfectly competitive market. The basic question is related to the amount of the output should produce, how much the profit will the firm earn, and if a loss, will the worthwhile to continue in this market in the long run, or should the firm exit from the market?. To develop economic model related to the output decision in perfect competition, there is a key assumption that used to analyze this model :
- The firm operates in a perfectly competitive market and therefore is a price taker.
- The firm makes the distinction between the short run and the long run.
- The firm’s objective is to maximize its profit in the short run. If one cannot earn a profit, then it seeks to minimize its loss.
- The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.
For the economic analysis, the company should have established a single clear objective for a function. Either the objective is the maximization of the profit in the short run or maximization revenue in the short run, the model function should differ. The opportunity cost in the cost structure of the firm is important to decision making. The company must check whether the going market price that probable to earn a revenue, covers the cost, and the costs incurred by forgoing alternatives activities.
THE TOTAL REVENUE-TOTAL COST APPROACH TO SELECTING THE OPTIMAL OUTPUT LEVEL
To analyze the optimal level of output, the company can compare the total revenue with the total cost schedules and find that level of output that either maximizes the firm’s profit or minimize its loss. In the table below, at level output 8, the company earns a maximized profit of $261.6.
The Marginal Revenue–Marginal Cost Approach To Finding The Optimal Output Level
In this analysis method, the company should decide the level point of input that the marginal cost, not excess marginal revenue. The table shows, at the level input 8 the marginal cost is $103.3 and marginal revenue is $110 still greater than marginal cost. But if the level input is 9, the marginal revenue of $110 will less than marginal cost $126.9. So the level input 8, results in a level optimum of output.
If the company 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.
ECONOMIC PROFIT, NORMAL PROFIT, LOSS, AND SHUTDOWN
In condition revenue of the company going slow down, the company must be careful to decide whether it is the right time to shut down or it still possible for the company to run the business. The company should calculate the cost and loss from the shutdown. If the company decides to shutdown it means there is no variable input and output anymore, but the company should consider the fixed cost that still exists.
For example, the fixed cost is $100 then the company wants to sell the fixed asset which has a market value of just $50. So the company will get a loss at this point. In the other condition, if the company continues the business with 1 input, there will a revenue and result in a profit or maybe a loss that better from the shutdown condition. The company should analyze and consider any factor to decide the better timing to make a shutdown.
THE COMPETITIVE MARKET IN THE LONG RUN
In the long run, the market price will settle at the point where these firms earn a normal profit. This is because, in the long period, prices that enable firms to earn above-normal profit would induce another firm to enter the market, and prices below the normal level would cause firms to leave the market. An understanding of the conditions motivating market entry or exit over the long run should lead the firms to consider the following points:
- The earlier the firm enters a market, the better its chances of earning an above-normal profit (assuming strong demand in this market).
- As new firms enter the market, firms that want to survive and maybe succeed must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors.
- Firms that find themselves incapable to compete based on cost might want to try competing based on product differentiation instead, although this is extremely difficult in this type of market.
Read : Cost Analysis for Managerial Decisions
PRICING AND OUTPUT DECISIONS IN MONOPOLY MARKETS
A monopoly market is consists of one market, the company is the market. In the absence of regulatory constraints, the monopoly stands in counterpoint to the perfectly competitive company. The key point is that a monopoly firm’s ability to set its price is limited by the demand curve for its product and the price elasticity of demand for its product. This ability is further limited by the possibility of the rising marginal cost of production.
At some point, the increasing cost of production of additional units of output will exceed the decreasing marginal revenue received from the sale of additional units. So thefirm that exercises monopoly power over its price should not set its price at the highest possible level. It should set at the right level or MR=MC.
THE IMPLICATION OF PERFECT COMPETITION AND MONOPOLY FOR MANAGERIAL DECISION MAKING
The most important thing that managers can learn from this perfectly competitive market analysis is that it is extremely difficult to make money in a highly competitive market. The only way for a company to survive in perfect competition is to be cost-efficient as possible because there is absolutely no way to control the price. In the competitive market, the company can move into the market before others start to enter. Enter the market even before the demand is high enough to support an above-normal price. In monopoly markets not sanctioned by the government via regulations or patent laws, a monopoly present manager with somewhat of a paradox.
Read : Pricing Strategy Monopolistic and Oligopoly