ECNE610
Managerial
Economics
MAY 2014
Chapter-8
1
Dr. Mazharul Islam
2
8
The Pricing and 5
Output Decisions:
Perfect Competition
Dr. Mazharul Islam
3
Lesson Objectives
Competition and market types
Pricing and output decisions in perfect
competition
Implications for managerial decisions
describe what happens in the long run
Dr. Mazharul Islam
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The four types of market
structure
 Petroleum
Dr. Mazharul Islam
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The characteristics of Perfect
Competition Market
 large
number of relatively small buyers and
sellers
 homogeneous (identical) products
 very easy market entry and exit
 price taker (no market power)
 perfect knowledge about their competitors
 Perfectly mobile factors of production
Dr. Mazharul Islam
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Pricing and output decisions
in perfect competition
Basic business decision process: entering a
market using the following questions:
 Should
the firm produce?
 If yes, how much (what quantity) should the firm
produce?
 if the firm produce such an amount, how much
profit or loss will be realized?
 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 the firm will eventually earn a
profit) or should the firm exit? Dr. Mazharul Islam
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Pricing and output decisions
in perfect competition
The Decision Rule:
Produce in the short-run if it can realize
1- A profit (or)
2- A loss less than its fixed costs
Dr. Mazharul Islam
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Pricing and output decisions
in perfect competition
Key assumptions of the perfectly
competitive market:
 the
firm 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
(or minimize loss) in the short run
 the firm includes its opportunity cost of
operating in a particular market as part of
its total cost of production
Dr. Mazharul Islam
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Pricing and output decisions
in perfect competition
Perfectly elastic demand
curve: consumers are willing
to buy as much as the firm is
willing to sell at the going
market price
 firm receives the same
marginal revenue from the
sale of each additional unit
of product; equal to the
price of the product
 no limit to the total
revenue that the firm can
gain in a perfectly
competitive market
Dr. Mazharul Islam
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Pricing and output decisions
in perfect competition
SHORT RUN PROFIT MAXIMIZATION:
Two Approaches...
First:
Total-Revenue -Total Cost
Approach
Second:
Marginal-Revenue -Marginal Cost
Approach
Dr. Mazharul Islam
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Pricing and output decisions
in perfect competition
Total-Revenue
-Total Cost Approach
compare the total revenue and total cost
schedules and find the level of output that
either maximizes the firm’s profits or
minimizes its loss.
Dr. Mazharul Islam
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Revenue of a competitive firm
Total revenue (TR)
= (price x quantity sold) = PQ
Average
revenue
Revenue of
typical unit
sold
Marginal
revenue
= TR/Q
= PQ/Q
=P
Change in TR
from additional
unit sold
= ∆TR/∆Q
=P
Dr. Mazharul Islam
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TOTAL REVENUE-TOTAL COST APPROACH
Total
Product
Total
Fixed
Cost
0
1
2
3
4
5
6
7
8
9
10
$ 100
100
100
100
100
100
100
100
100
100
100
Total
Variable
Cost
$
0
90
170
240
300
370
450
540
650
780
930
Total
Cost
$ 100
190
270
340
400
470
550
640
750
880
1030
Price: $130
Total
Revenue
Profit
$
0
130
260
390
520
650
780
910
1040
1170
1300
- $100
- 60
- 10
+ 50
+ 120
+ 180
+ 230
+ 270
+ 290
+ 290
+ 270
Dr. Mazharul Islam
Total revenue and total cost
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$1,800
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
900
800
700
600
500
400
300
200
100
0
Break-Even Point
(Normal Profit)
Total
Revenue
Maximum
Economic
Profits
$290
Total
Cost
Break-Even Point
(Normal Profit)
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Dr. Mazharul Islam
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Marginal-Revenue -Marginal Cost Approach
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 (ie.
MR=MC)
Note: for the perfectly competitive firm, the
MR=MC rule may be restated as P=MC
because P=MR in perfectly competitive market
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MARGINAL REVENUE-MARGINAL COST APPROACH
Average Average
Average
Price =
Total
Fixed
Variable
Total Marginal Marginal Economic
Total
Cost
Cost
Revenue Profit/Loss
Product Cost
Cost
0
1
2
3
4
5
6
7
8
9
10
$90.00 $190.00
The
85.00
135.00
113.33
same80.00
profit
75.00
100.00
74.00
94.00
maximizing
75.00
91.67
77.14
91.43
result!
81.25
93.75
$100.00
50.00
33.33
25.00
20.00
16.67
14.29
12.50
11.11
10.00
86.67
93.00
97.78
103.00
90
80
70
60
70
80
90
110
130
150
$ 130
130
130
130
130
130
130
130
130
130
- $100
- 60
- 10
+ 50
+ 120
+ 180
+ 230
+ 270
+ 290
+ 290
+ 270
Dr. Mazharul Islam
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Profit Maximization Position
$200
Cost and Revenue
Economic Profit
150
$130.00
MC
D=MR=AR
ATC
AVC
100
$97.78
50
0
1 2 3 4 5 6 7 8 9 10
Dr. Mazharul Islam
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Loss Minimization Position
$200
Economic Loss
MC
Cost and Revenue
150
ATC
AVC
100
$91.67
$81.00
50
0
D=MR=AR
1 2 3 4 5 6 7 8 9 10
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 Contribution
margin:
the amount by which
total revenue exceeds
total variable cost
CM = TR – TVC
 if CM > 0, the firm
should continue to
produce in the short
run in order to offset
some of the fixed cost
Dr. Mazharul Islam
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 Shutdown
point: the lowest price at which
the firm would still produce.
At the shutdown point, the price is equal
to the minimum point on the AVC.
If the price falls below the shutdown
point, revenues fail to cover the fixed
costs and the variable costs. The firm
would be better off if it shut down and
just paid its fixed costs.
Dr. Mazharul Islam
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How about the long-run?
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.
Dr. Mazharul Islam
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LONG-RUN EQUILIBRIUM
FOR A COMPETITIVE FIRM
MC
Price
ATC
P
MR
Price = MC = Minimum ATC
(normal profit)
Q
Quantity
Dr. Mazharul Islam
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Observations in perfectly competitive
markets:
 the
earlier the firm enters a market, the
better its chances of earning above-normal
profit.
 as new firms enter the market, firms 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 unable to compete
on the basis of cost might want to try
competing on the basis of product
differentiation instead.
Dr. Mazharul Islam
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Implications of perfect competition
for decision making
most
important lesson is that it is
extremely difficult to make money.
must
be as cost efficient as possible.
it
might pay for a firm to move into a
market before others start to enter.
Dr. Mazharul Islam
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The firm’s decision to cease
production
Ceasing production
Short-run = Shutdown
Long-run = Exit
Conditions
TR<VC
Conditions
TR/Q < VC/Q
TR/Q < TC/Q
P < AVC
P < ATC
TR<TC
Dr. Mazharul Islam
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Case Study: Wheat European Union





There are some large wheat farms in the EU, but they
are very small in relation to the whole wheat-growing
industry.
An individual farm could increase its output many
times over without have any noticeable effect on
total supply of wheat in the EU.
A single farm is not able to affect the price of wheat
in the EU, since it cannot shift the industry supply
curve.
The farm has to sell at whatever the industry price is.
In addition wheat is wheat, and so there is no way to
tell one farm’s wheat from another.
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Where the Perfect Competition model fails:
 Although
firms are relatively free to enter or leave
the wheat industry, there are significant costs in
doing either and these may affect the decisions of
firms.
 Although information is fairly open in the industry, it
is unlikely that producers and consumers will have
perfect knowledge.
 The wheat industry in the EU may be close to being
a perfectly competitive market, but not a precise
one.
BREAK-EVEN ANALYSIS
A
breakeven analysis is used to
determine how much sales
volume your business needs to
start making a profit in short run.
The breakeven analysis is
especially useful when you're
developing a pricing strategy,
either as part of a marketing plan
or a business plan.
USES OF BREAK EVEVN POINT
 An
important tool in terms of short-term
planning and decision making
 It looks at the relationship between costs,
revenue, output levels and profit
 Helpful in deciding the minimum quantity of
sales
 Helpful in the determination of tender price
 Helpful in examining effects upon
organization’s profitability
 Helpful in deciding about the substitution of
new plants
 Helpful in sales price and quantity
 Helpful in determining marginal cost
DECISION MAKING
How
many units must be sold
to breakeven?
How many units must be sold
to achieve a target profit?
Should a special order be
accepted?
How will profits be affected if
we introduce a new product
or service?
BREAK
EVEN POINT:
Number of units that must be sold
in order to produce a profit of
zero (but will recover all
associated costs).
Break Even Point (IN UNIT)=
Fixed Cost /(Selling Price per unitVariable Unit Cost)
 Break Even Point (in SAR)=
Fixed Cost /(Selling Price per unitVariable Unit Cost)
For example
 Suppose
that your fixed costs for producing
100,000 product were SAR 30,000 a year.
 Your variable costs are SAR2.20 materials,
SAR4.00 labor, and SAR0.80 overhead, for a
total of SAR7.00 per unit.
 If you choose a selling price of SAR12.00 for
each product, then:
 30,000 divided by (12.00 - 7.00) equals 6000
units.
 This is the number of products that have to
be sold at a selling price of SAR12.00 before
your business will start to make a profit.
Target Profits
What
if a firm doesn’t just
want to breakeven – it
requires a target profit
Contribution per unit will
need to cover profit as well
as fixed costs
Required profit is treated as
an addition to Fixed Costs
Example
Using
the
following
data,
calculate the level of sales
required to generate a profit of
SAR10,000:
Selling Price = SAR35
Variable Cost = SAR20
Fixed Costs = SAR50,000
Solution
Contribution
= SAR35 – SAR20 =
SAR15
Level of sales required to
generate profit of SAR10,000:
SAR50,000 + SAR10,000
SAR15
= 4000 units
LIMITATIONS

Break-even analysis is only a supply side (costs only) analysis, as
it tells you nothing about what sales are actually likely to be for
the product at these various prices.

It assumes that fixed costs (FC) are constant.

It assumes average variable costs are constant per unit of
output, at least in the range of likely quantities of sales.

It assumes that the quantity of goods produced is equal to the
quantity of goods sold (i.e., there is no change in the quantity
of goods held in inventory at the beginning of the period and
the quantity of goods held in inventory at the end of the
period.

In multi-product companies, it assumes that the relative
proportions of each product sold and produced are constant.
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Do you have any question?
Dr. Mazharul Islam