Pricing Under Perfect

UNIT 11 PRICING UNDER PERFECT Competition and Pure

Monopoly
COMPETITION AND PURE
MONOPOLY
Structure
11.0 Objectives
11.1 Introduction
11.2 Characteristics of Perfect Competition
11.3 Profit Maximizing Output in the Short Run
11.4 Profit Maximizing Output in the Long Run
11.5 Characteristics of Monopoly
11.6 Profit Maximizing Output of a Monopoly Firm
11.7 Welfare: Perfect Competition vs Monopoly
11.8 Implications of Perfect Competition and Monopoly for Managerial
Decision Making
11.9 Let Us Sum Up
11.10 Key Words
11.11 Terminal Questions

11.0 OBJECTIVES
After going through this unit, you should be able to:
 describe the characteristics of pure/perfect competition and pure
monopoly;
 identify the equilibrium conditions for a firm and the industry in a
perfectly competitive situation;
 examine price-output decisions under pure monopoly; and
 analyze the relevance of pure/perfect competition and pure monopoly.

11.1 INTRODUCTION
In the preceding unit, you have been introduced to the concept of market
structure and the impact it has on the competitive behaviour of firms. You
must have noted that the number and size of the firms is an important
determinant of the structure of the industry and/or market.

In this unit, we shall analyze the behaviour of a firm under two different
market structures, namely, pure/perfect competition and monopoly. The
crucial parameter is the size of the constituent firms in relation to the total 245
Pricing Decisions industry’s output. Throughout this unit, we go by the assumption that the
firms are guided by profit maximization.

11.2 CHARACTERISTICS OF PERFECT

COMPETITION
Perfect competition is a form of market in which there are a large number of
buyers and sellers competing with each other in the purchase and sale of
goods, respectively and no individual buyer or seller has any influence over
the price. Thus perfect competition is an ideal form of market structure in
which there is the greatest degree of competition.

A perfectly competitive market has the following characteristics:

1. There are a large number of independent, relatively small sellers and

buyers as compared to the market as a whole. That is why none of them
is capable of influencing the market price. Further, buyers/sellers should
not have any kind of association or union to arrive at an understanding
with regard to market demand/price or sales.

2. The products sold by different sellers are homogenous and identical.

There should not be any differentiation of products by sellers by way of
quality, variety, colour, design, packaging or other selling conditions of
the product. That is, from the point of view of buyers, the products of
competing sellers are completely substitutable.

3. There is absolutely no restriction on entry of new firms into the industry

and the existing firms are free to leave the industry. This ensures that
even in the long run the number of firms would continue to remain large
and the relative share of each firm would continue to remain insignificant.

4. Both buyers and sellers in the market have perfect knowledge about the
conditions in which they are operating. Buyers know the prices being
charged by different competing sellers and sellers know the prices that
different buyers are offering.

5. The distance between the locations of competing sellers is not significant

and therefore the price of the product is not affected by the cost of
transportation of goods. Buyers do not have to incur noticeable
transportation costs if they want to switch over from one seller to
another.
246
The characteristics of perfect competition are summarized in Table 11.1 Pricing Under Perfect
Competition and Pure
Number and size of distribution of Many small sellers. No individual Monopoly

sellers. seller is able to exercise a significant

influence over price.
Number and size distribution of Many small buyer
buyers No buyer is able to exert a significant
influence over price.
Product differentiation. No product differentiation.
Decisions to buy are made on the
basis of price.
Conditions of entry and exit. Easy entry and exit.
Resources are easily transferable
among industries.

As mentioned in the previous unit, it is difficult to find a market that satisfies

all the text book conditions of perfect competition. There are markets that
come close to fulfilling these stringent conditions, but none that completely is
in synchronization with all of them. You might well ask the rationale for
studying this market structure if it does not exist in the real world. The answer
is that perfect competition is the ideal market, and serves as a benchmark. We
can use the outcomes of other markets to compare with outcomes that would
have been achieved under perfect competition. For instance, if the market is
competitive, prices would be lower and closer to costs, while if the market is
monopolized then prices are likely to be higher. Another useful comparison
relates to the concept of consumer’s surplus.

Intuitively, consumer’s surplus can be thought of as the difference between

the maximum amount the consumer is willing to pay for a product and the
amount he actually pays. Think about your purchase of a big ticket item such
as a camera. You have a price in mind that is the maximum you are willing to
pay. The difference between this and the price actually paid is the consumer’s
surplus1.

In perfectly competitive markets, consumer’s surplus is the maximum, while

in monopoly markets it is low. In fact, it is the endeavour of monopolies to
capture as much of the consumer’s surplus as possible. When a perfectly
competitive industry gets monopolized there is a transfer of surplus from the
consumer to the producer. Or stated differently, the producer is able to
increase his surplus (or profit) at the expense of the consumer. On the other
hand, when a monopolized industry becomes competitive, there is transfer

1
Note that you will never pay more than maximum amount. 247
Pricing Decisions from producers to the consumers; i.e. consumers become better off when
there is increased competition. An illustration of this can be gauged from the
conduct of the automobile industry in India since it was deregulated in 1991.
The consumers have benefited from competition in the sector and one can
definitely assert that producer margins (or surplus) have declined to the
benefit of the consumers.

Activity 1

Grocery stores in a large city appear to have a perfectly competitive market

structure as there are many sellers and each seller is relatively small who is
selling similar products.

a) Do you think that grocery stores can be an example of perfect

competition? Discuss.

b) What in your opinion is the market structure of grocery stores and why?

11.3 PROFIT-MAXIMISING OUTPUT IN THE

SHORT RUN
Having examined the rationale for studying perfectly competitive markets, let
us analyze the profit-maximizing output of a profitable competitive firm in
the short run. As you already know, the short run is defined as a period of
time in which at least one input is fixed. Often the firm’s capital stock is
viewed as the fixed input. Accordingly, this analysis assumes that the number
of production facilities in the industry and the size of each facility do not
change because the period being considered is too short to allow firms to
enter or leave the industry or to make any changes in their operations.

Under perfect competition, since an individual firm cannot influence the

market price by raising or lowering its output, the firm faces a horizontal
demand curve, that is, the demand curve of any single firm is perfectly elastic
– its elasticity is equal to infinity at all levels of output. If a firm charges a
price slightly higher than the prevailing market price, demand for that firm
will fall to zero because there are many other sellers selling exactly the same
product. On the other hand, if a firm reduces its price slightly, its demand will
increase to infinity and thus other firms will match the low price.

A firm under perfect competition is a price-taker and not a price-maker.

Because an individual firm’s demand or Average Revenue (AR) curve is
horizontal under perfect competition, the Marginal Revenue (MR) curve of
the firm is also horizontal coincides with the AR curve. In other words, AR
248
and MR are constant and equal at all levels of output. You should satisfy Pricing Under Perfect
Competition and Pure
yourself that if price (i.e. average revenue) is constant, marginal revenue will Monopoly
be equal to price2.

The price-output determination and equilibrium of the firm under perfect

competition may be explained through a numerical example. Suppose the
demand and supply conditions of a product are represented by the following
equations:

Aggregate Demand: Q = 25 – 0.5 P

Aggregate Supply: Q = 10 + 1.0 P

The equilibrium price would be at a point where aggregate demand equals

aggregate supply

25 – 0.5 P = 10 + 1.0 P

or P = 10

Industry output at P = 10 is obtained by substituting this price into either the

demand or supply function:

Q = 10 + 1.0 (10)

= 20

Therefore equilibrium price, P = 10 and equilibrium output, Q = 20.

Figure 11.1 shows that when the market price is at P1, demand and marginal
revenue facing the firm are D1 and MR1. The optimal output for the firm to
produce is at point A, where Marginal Cost (MC) = P1, and the firm will
produce Q1 units of output. At Q1 level of output, the Average Total Cost
(ATC) is less than the price and the firm makes an economic profit.

Suppose the market price falls to P2, price equals MC at point C. Because at
this level of output (Q2) average total cost is greater than price, total cost is
greater than total revenue, and the firm suffers losses. The amount of loss is
the loss per unit (CR) times the number of units produced (Q2).

2
If p=10 and q=1, TR =10; if p = 10 and q=2, TR = 20; MR is thus 10 and so on. MR will always = 10
and therefore will be the same as price as long as price is constant. 249
Pricing Decisions Figure 11.1: Profit Maximizing Equilibrium in the Short Run

At price level P2, demand is D2 = MR2, there is no way that the firm can earn
a profit. This is because at every output level average total cost exceeds price
(ATC > P). The firm will continue to produce only if it loses less by producing
than by closing its operations entirely. When the firm produced zero output,
total revenue would also be zero and the total cost would be the total fixed
cost. The loss would thus be equal to total fixed cost. If the firm produces at
MC = MR2 (point C), total revenue is greater than total variable cost, because
P2 > AVC at Q2 units of output. The firm will be in a position to cover all its
variable costs and still has CD times (as in graph 11.1) the number of units
produced (Q2) left over to pay part of its fixed cost. This way the firm suffers
a smaller loss when it continues production than it shut down its operations.

At market price P3, demand is given by D3 = MR3. The equilibrium output Q3

would be at T where MC = P3. At this output level, since the average variable
cost of production exceeds price, the firm not only loses all its fixed costs but
would also lose Rs. ST per unit on its variable costs as well. The firm could
improve its earnings situation by producing zero output and losing only fixed
costs. In other words, when price is below average variable cost at every level
of output, the short-run loss-minimizing output is zero.

To reiterate, the profit maximizing output for a perfectly competitive firm in

the short run is to set P = MC. Since P = MR, this is equivalent to setting MR
= MC. In the short run, as the above discussion shows, it is possible for the
firm to make above normal or economic profit. On the other hand, it is also
possible for the firm to make losses, as long as those losses are less than its
250
total fixed costs. In other words, the firm will continue to produce as long as Pricing Under Perfect
Competition and Pure
P>AVC in the short run, because this is a better strategy than shutting down.
Monopoly
The firm will shut down only if P< AVC.

11.4 PROFIT-MAXIMISING OUTPUT IN THE

LONG RUN
Now let us analyze the profit maximizing output decision by perfectly
competitive firms in the long run when all inputs and therefore costs are
variable. In the long run, a manager can choose to employ any plant size
required to produce the efficient level of output that will maximize profit.
The plant size or scale of operation is fixed in the short run but in the long
run it can be altered to suit the economic conditions.

In the long run, the firm attempts to maximize profits in the same manner as
in the short run, except that there are no fixed costs. All costs are variable in
the long run. Here again the firm takes the market price as given and this
market price is the firm’s marginal revenue. The firm would increase output
as long as the marginal revenue from each additional unit is greater than the
marginal cost of that unit. It would decrease output when marginal cost
exceeds marginal revenue. This way the firm maximizes profit by equating
marginal cost and marginal revenue (MR = MC; as discussed above).

Figure 11.2: Profit Maximizing Equilibrium in the Long Run

The firm’s long run average cost (LAC) and marginal cost (LMC) curves are
shown in Figure 11.2. The firm faces a perfectly elastic demand indicating
the equilibrium price (Rs. 17) which is the same as marginal revenue (i.e., D
251
Pricing Decisions = MR = P). You may observe that as long as price is greater than LAC, the
firm can make a profit. Therefore, any output ranging from 20 – 290 units
yields some economic profit to the firm. In figure 11.2, B and B1 are the
breakeven points, at which price equals LAC, economic profit is zero, and the
firm can earn only a normal profit.

The firm, however, earns the maximum profit at output level 240 units (point
S). At this point marginal revenue equals LMC and the firm would ideally
select the plant size to produce 240 units of output. Note that in this situation
the firm would not produce 140 units of output at point M, which is the
minimum point of LAC. At this point marginal revenue exceeds marginal
cost, so the firm can gain by producing more output. As shown in figure 11.2,
at point S total revenue (price times quantity) at 240 units of output is equal
to Rs. 4080 (= Rs. 17 * 240), which is the area of the rectangle OTSV. The
total cost (average cost times quantity) is equal to Rs. 2,880 (= Rs. 12 * 240)
which is the area of the rectangle OURV. The total profit is Rs. 1,200 = (Rs.
17 – Rs. 12) * 240, which is the area of the rectangle UTSR.

Thus, the firm would operate at a scale such that long run marginal cost
equals price. This would be the most profitable situation for an individual firm
(illustrated in figure 11.2). Therefore, if the price is Rs. 17.00 per unit, the
firm will produce 240 units of output, generating a profit of Rs. 1,200.00.
This profit is variously known as above normal, super normal or economic
profit. The crucial question that one needs to ask is whether this is a
sustainable situation in a perfectly competitive market i.e. whether a firm in a
perfectly competitive industry can continue to make positive economic profits
even in the long run? The answer is unambiguously no.

This result derives from the assumption that in a perfectly competitive market
there are no barriers to entry. Recall that in a market economy, profit is a
signal that guides investment and therefore resource allocation decisions. In
this case, the situation will change with other prospective entrants in the
industry. The economic force that attracts new firms to enter into or drives
out of an industry is the existence of economic profits or economic losses
respectively. Economic profits attract new firms into the industry whose entry
increases industry supply. As a result, the prices would fall and the firms in the
industry adjust their output levels in order to remain at profit maximization
level. This process continues until all economic profits are eliminated. There
is no longer any attraction for new firms to enter since they can only earn
normal profits. By observing figure 11.2 you should try to work out the price
that will prevail in this market in the long run when all firms are earning
normal profit.

252
Analogous to economic profit which serves as a signal to attract investment, Pricing Under Perfect
Competition and Pure
economic losses drive some existing firms out of the industry. The industry Monopoly
supply declines due to exit of these firms which pushes the market prices up.
As the prices have risen, all the firms in the industry adjust their output levels
in order to remain at a profit maximization level. Firms continue to exit until
economic losses are eliminated and economic profit becomes zero, that is,
firms earn only a normal rate of profit.

Activity 2

Assume that all the assumptions of perfect competition hold true.

a) What would be the effect of technological change in the long-run under

perfect competition?

b) What conditions, in your opinion, would encourage research and

development activities in the industry operating under perfect
competition?

11.5 CHARACTERISTICS OF MONOPOLY

Monopoly can be described as a market situation where a single firm
controls the entire supply of a product which has no close substitutes. The
market structure characteristics of monopoly are listed below:

 Number and size of distribution of sellers Single seller

 Number and size of distribution of buyers Unspecified
 Product differentiation No close substitutes
 Conditions of entry and exit Prohibited or difficult
entry

Though perfect competition and monopoly are the two extreme cases of market
structure, they both have one thing in common – they do not have to compete
with other individual participants in the market. Sellers in perfect competition
are so small that they can ignore each other. At the other extreme, the
monopolist is the only seller in the market and has no competitors. The market
or industry demand curve and that of the individual firm are the same under
monopoly since the industry consists of only one firm.

Managers of firms in a perfectly competitive market facing a horizontal

demand curve would have no control over the price and they simply choose
the profit maximizing output. However, the monopoly firm, facing a
downward-sloping demand curve (see Figure 11.3) has power to control the
price of its product. If the demand for the product remains unchanged, the
monopoly firm can raise the price as much as it wishes by reducing its output.
On the other hand, if the monopoly firm wishes to sell a larger quantity of its
product it must lower the price because total supply in the market will 253
Pricing Decisions increase to the extent that its output increases. While an individual firm under
perfect competition is a price-taker, a monopolist firm is a price-maker. It
may, however, be noted that to have price setting power a monopoly must not
only be the sole seller of the product but also sell a product which does not
have close substitutes.

11.6 PROFIT MAXIMISING OUTPUT OF A

MONOPOLY FIRM
Often students are tempted into thinking that since a monopolist is the only
producer in the market, he will be able to charge any price for the product.
While a monopolist will certainly charge a high price, it must also ensure that it
is maximizing profit. Our earlier discussion proves that a profit maximizing
monopoly firm determines its output at that level where its marginal cost (MC)
curve intersects its downward sloping marginal revenue (MR) from below.
Since the MR curve of the monopoly firm is below its average revenue or
demand curve at all levels of output, and at the equilibrium output level
marginal revenue is equal to marginal cost, the profit maximizing monopoly
price is greater than marginal cost. You may recall, the profit maximizing price
under perfect competition is equal to marginal cost. Since the demand curve of
the monopoly firm is above the firm’s average cost curve, the price at
equilibrium output is also greater than average cost. Therefore, super-normal
profits are a distinguishing feature of equilibrium under monopoly.

Figure 11.3: Equilibrium output and price under monopoly

The firm would enjoy such super normal profits even in the long run because it
254 is very difficult for new firms to enter in a monopolized market.
The determination of profit maximizing equilibrium output and price under Pricing Under Perfect
Competition and Pure
monopoly is shown in figure 11.3. DD and MR are the downward sloping
Monopoly
demand (or average revenue curve) and marginal revenue curves respectively
of the monopoly firm. AC and MC are its average cost and marginal cost
curves. At point E, MC intersects MR from below. Corresponding to E, the
profit maximizing equilibrium output is OQ. At OQ output, the price is OP =
QR; and average cost is OC = QK. The monopoly profits are equal to price
minus average cost multiplied by output i.e., (OP – OC) * OQ = PC *CK =
PCKR. The rectangle area PCKR represents the super normal profits of the
monopoly firm.

Monopoly Power

The above analysis shows that whereas under perfect competition, price is
equal to marginal cost and profits are normal in the long run; under
monopoly, price is greater than marginal cost and profits are above normal
even in the long run.

Therefore, the monopolist has power to charge a price which is higher than
marginal cost and earn super normal profits. The extent of monopoly power
of a firm can be calculated in terms of how much price is greater than
marginal cost. Recall that a perfectly competitive firm sets P = MC. Thus the
greater the difference, the greater is the monopoly power. Economist A.P.
Lerner devised such an index to measure the degree of monopoly power and
which has come to be known as the Lerner index. According to this index,
the monopoly power of a firm is —

µ = (P – MC)/P

Where
P = Price of the firm’s product
MC = Firm’s marginal cost

We know that at equilibrium output MC = MR and MR = P (1 – 1/e) where e

is the price elasticity of demand.

µ = (P – MC)/P
µ = (P – MR)/P = 1 – (MR/P)
But (MR/P) = (1-1/e)
µ = 1 – (1 – 1/e)
µ = 1/e

The monopoly power of a firm is inversely related to elasticity of demand for

its product. The less elastic the demand for its product, the greater would be
its monopoly power, and vice versa. As we have discussed in Block 2,
elasticity of demand depends on the number and closeness of the substitutes
available for a product. In the real world we find some essential goods and 255
Pricing Decisions services like life saving medicines, petroleum, cooking gas, railways etc.
which enjoy a high degree of monopoly power because the demand for these
products is highly inelastic. Left to itself the monopoly could price such
inelastic products at rates that do not meet the social objectives of the
government and policy makers. Thus we often witness government
intervention in monopolies. For example, Railway ticket prices are fixed by
the government and electricity tariffs are set by a regulatory authority. The
reason why monopolies need to be regulated is discussed in the next section.

11.7 WELFARE: PERFECT COMPETITON VS

MONOPOLY
Our discussion reveals that in a pure monopoly price will generally be greater
than marginal cost and that the firm is able to generate super normal profits at
the expense of welfare of consumers and society even in the long run. Recall
that key conditions that give rise to monopolies are economies of scale and
barriers to entry. On the other hand, production processes like food
processing, textiles, garments, wood and furniture, it is relatively easy to
enter the market as a supplier – for example, capital requirements are low and
sunk costs are also low. Many service industries like travel agencies fall into
this category. In such industries, competition ensures that prices are set
‘right’ and moreover the threat of entry ensures that prices never exceed long-
run average cost (for example, marginal companies in the industry cannot
persistently earn above average profits). Moreover, competition also ensures
that price equals long-run marginal cost. Hence the price of a good accurately
reflects the opportunity cost of manufacturing it.

Problems arise from leaving everything to the market, however when a

situation of monopoly occurs. In economists’ jargon, there are economies of
scale to be exploited when one company meets market demand. There are
typically also major barriers to entry in such industries. Most public utilities –
electricity generation, water supply, gas supply and perhaps national
telecommunications systems – have technologies of this sort. There are
several special problems for these industries.

First, their size and capital intensity often puts particular strain on private
capital markets in satisfying their investment needs. In India, in the 1990s
strain was felt instead on the public coffers, and this was a major factor
behind the move towards disinvestment and privatization. Hence, while for
example automobile or chemicals manufacture are also characterized by huge
scale economies, governments have rarely seen it as their role to regulate
companies in these industries. The question for policy makers is what to do
about natural monopolies like power and water supply. Left to themselves,
they will charge monopoly prices and restrict output. The absence of any
competitive threat will also probably leave such organizations wasteful,
inefficient and sluggish. Since all costs can be passed on to the consumers,
256
there will be little incentive for managers to keep them under control. Pricing Under Perfect
Competition and Pure
Experience from, for example, the railways suggests that it will not be long
Monopoly
before the absence of competitive pressures may damage the motives for
innovation and change, so crucial in such capital-intensive sectors. Thus in
some cases a regulator is appointed who must fix the natural monopolist’s
price. In India, privatization of power and telecommunications has been
accompanied by the creation of a regulator, while there is no such institution for
cement, automobile or chemical industry.

The above discussion can also be illustrated with the help of Figure 11.4.
Assume a perfectly competitive industry. We know that price would be Pc
and quantity supplied Qc.

Figure 11.4: Evaluation of Monopoly

The consumer’s surplus will be the area Pc AD. Now consider output and
price of the profit maximizing monopolist. As indicated in the figure, price
would be Pm and quantity would be Qm. Notice that the monopolist will
charge a higher price and produce a lower quantity as expected. The
consumer surplus is reduced to PmAB. The rectangle Pc Pm BC that was
part of consumer surplus under competition is now economic profit for the
monopolist. This economic profit represents income redistribution from
consumers to producers. Further, there is also a deadweight loss to society
represented by the area BCD that represents loss of consumer surplus that
accrued under competition, but is lost to society because of lower production
levels under monopoly.

If we now consider the reverse case i.e. a monopoly being broken to foster
competition, the result will be transfer of income from producers to
consumers and elimination of deadweight loss. Herein lies the economic 257
Pricing Decisions basis for regulation of monopoly firms. It is to generate the outcomes of
competitive markets and pass these benefits to consumers in the form of
lower prices. If competition exists in markets then arguably, that is the best
regulation. If it does not, and the industry is envisaged to play a social role,
regulation of monopoly becomes an important policy objective.

Activity 3

1. Give few examples of market situation where monopoly exists and

explain.

11.8 IMPLICATIONS OF PERFECT

COMPETITION AND MONOPOLY FOR
MANAGERIAL DECISION MAKING
The assumptions underlying perfect competition market are very restrictive.
Few markets are found with characteristics of many small sellers, easy entry
and exit, and an undifferentiated product. Normally, a majority of modern
industries operate under conditions of oligopoly or monopolistic competition.
You will study these two market structures in detail in Unit 13.

Perfect competition and monopoly are the two extreme market conditions
which we rarely come across in the real world of business. Then the question
arises as to why study them? It is useful to think of perfect competition and
pure monopoly as extremes with other market structures placed in between.
There are many industries that have most of the characteristics of perfect
competition or monopoly. The two extreme models therefore serve as
benchmarks and provide guidance in making decisions.

Consider the following case. A multinational soft drink company P was in

bankruptcy for the second time. The President of the Company tried to sell it
to soft drink Company C, but the C Company wanted no part of the deal. In
order to reduce costs the President purchased a large supply of recycled 12-
ounce beer bottles. At that time, soft drink P and C were sold in six ounce
bottles. Initially Company P priced the bottles at 10 cents, twice the amount
of the original six ounce bottles, but with little success. Then the President of
the Company had the brilliant idea of selling the 12 ounce bottles of softdrink
P at the same price as the six ounce bottles of softdrink C. Then scale took off
and shortly softdrink P was out of bankruptcy and soon making a very nice
profit.

Softdrink P pricing decision was clearly crucial to the life of the firm. The
primary background necessary for understanding the pricing decision is a
good understanding of the law of demand – i.e. as price goes up, demand
goes down – and some understanding of the amount by which a price
increase effects a quantity decrease – i.e. the price elasticity of demand. We
258
will start by examining the polar cases of pricing under perfect competition Pricing Under Perfect
Competition and Pure
and pricing under monopoly, and then move on to examining Softdrink P and
Monopoly
C company's situation.

Alfred Marshall, a famous 19th Century economist, used a fish market as an

example of perfect competition. For the sake of argument, consider a fish
seller selling cod. How would s/he price his product? First, s/he would look
around and find out at what price her/his numerous competitors were selling
cod. s/he certainly could not price above the competitors; since cod is pretty
much identical and consumers should not care from whom they purchase.
Furthermore, in fish markets, it is quite easy for consumers to compare
prices. So, if s/he priced above her/his competitors, s/he would not sell any
fish. Suppose s/he decided to price below her/his competitors. All of the
customers would certainly purchase from him. However, if s/he were still
making a profit, the other competitors would also be making a profit at the
lower price and would match the price cut in order to retain their customers.
They may even consider lowering price more, if they could still make a profit
and capture further customers.

This reasoning, along with the ease of entry for new fish seller, if there is a
profit to be made (which prevents collusion among fish seller already in the
market), ensures that the price being charged is equal to the cost of supplying
an additional fish, or the marginal cost. A fish seller will be a price-taker,
setting her/his price identically to her/his competitors’ prices. A firm is a
monopoly if it has exclusive control over the supply of a product or service.
Therefore, a monopolist, in her/his pricing decisions, cannot consider the
pricing decision of rival firms. So, what does s/he consider?

The smart monopolist considers the incremental effect of his decision, i.e.
what is the revenue to be received from selling one additional unit of a
product and what are the costs of selling one additional unit of a product.
Certainly, if the costs of selling one additional unit of a product exceed the
revenues, the monopolist would certainly not want to sell that additional
product. The law of demand says that s/he could raise the price of her/his
product and thus sell less. Alternatively, if the revenues of selling an
additional unit of a product exceed the costs of selling that unit, the
monopolist should want to sell more units. The law of demand says that s/he
could sell more by lowering his price.

Thus, by setting the price correctly, the monopolist can sell the exact number
of units such that the costs of selling one additional unit exactly equals the
revenues of selling the additional unit, which, by the above reasoning, is the
only optimal price. However, there is an additional complication: the costs of
selling one additional unit do not include any part of the salary of the CEO or
the rental costs of the plant, both must be paid whether or not the additional
unit is sold. Thus, in the long run, if a monopolist cannot cover his overhead
by pricing in the optimal manner, he should shut down.
259
Pricing Decisions The situation involving soft drink P and soft drink C clearly differs from
either of the above scenarios, but what can we learn from both the cases?
First, P clearly saw that C was pricing the six-ounce bottles at 5 cents. By
pricing the 12- ounce bottles at 5 cent also, P made the bet that C would not
cut its price. C did not see the need to cut price because its product was
different from P and it did not fear losing many of its customers. Whether the
gain in revenues resulting from increased demand would offset the loss in
revenue from the lower price depends on the price elasticity of demand. The
price elasticity of demand faced by soft drink P company depends on soft
drink C response to the price cut and the consumer’s responses. As we saw
above, P made the assumption that C would not cut price. P counted on a
highly elastic consumer response, that is the percentage change in quantity
purchased by the consumer due to the lower price, and therefore profits
would accrue to P.

What other concerns you think played a part in the soft drink P company's
decision?

11.9 LET US SUM UP

In this unit, you have studied the market forces operating in perfect
competition and pure monopoly; and the pricing and output decisions in these
two market structures. The perfect competition model assumes a large
number of small sellers and buyers, identical products, and an easy entry and
exit conditions. In perfect competition, firms face a horizontal demand curve
at equilibrium price. Price is determined by the interaction of the market
supply and demand curves. Since no single firm has control over price, the
objective of managers is to determine the level of output that maximizes
profit.

The perfectly competitive firm maximizes profit at a point where price equals
marginal cost. The firm can make an economic profit or loss in the short run,
depending on market price. If the price drops below average variable cost, the
firm should shut down. Or even if the firm is making a profit in the short run,
it may wish to change its plant size or capacity in the long run in order to earn
more profit.

The monopolist is a single seller of a differentiated product. Entry into the

market is difficult or prohibited. Being the single seller, the monopolist has
power over price. For maximizing profits, the firm produces until marginal
revenue equals marginal cost. This way the monopolist earns economic
profits in both the short run and long run as well because entry is restricted
for new firms.

In the real world, few market structures meet the restrictive assumptions for
perfect competition or monopoly. Still, these two models are useful because
many industries have the characteristics of perfect competition or monopoly.
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Moreover, the perfectly competitive model serves as a benchmark for Pricing Under Perfect
Competition and Pure
evaluating the performance of actual markets and provides guidance for
Monopoly
public policy.

11.10 KEY WORDS

Differentiated Products: Products which are similar in nature but differ in

terms of packing, look etc.

Economic Costs include normal profits.

Economic Profit represents an above-normal profit situation.

Equilibrium of a Firm (MR = MC) represents profit maximizing price-

output combination. In a situation where maximum profits mean a loss, the
equation gives loss.

Equilibrium of an Industry is stated in terms of the condition of normal

profit AR = AC such that the size and structure of the industry are strictly
defined in terms of number of firms.

Profit Maximization: It is the condition where marginal revenue and

marginal cost are in equilibrium.

11.11 TERMINAL QUESTIONS

1. Vegetable market is an example, closest to the pure competition. Discuss.

2. Suppose a firm A has

Q = 20 – 0.3 P
And
Aggregate supply as
Q = 10+0.2 P
What would be the equilibrium price and the equilibrium output of the
firm A?

3. Suppose a small locality has a single grocery store selling multiple products.
a. Is it a monopoly?

b. If yes, then give arguments in support of your answer.

4. Discuss the relevance of perfect competition and monopoly in the present

context.

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Pricing Decisions
FURTHER READINGS
Mote, V. L., Paul, S., & Gupta, G. S. (2016). Managerial Economics:
Concepts and Cases, Tata McGraw-Hill, New Delhi.

Maurice, S. C., Smithson, C. W., & Thomas, C. R. (2001). Managerial

Economics: Applied Microeconomics for Decision Making. McGraw-Hill
Publishing.

Dholakia, R., & Oza, A. N. (1996). Microeconomics for Management

Students. Oxford University Press, Delhi.

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