Pricing Under Pure Competition and Pure Monopoly

Introduction

Market structure fundamentally shapes how firms make pricing decisions. The number and size of firms in relation to the total industry's output is a crucial determinant of competitive behavior. In this unit, we analyze firm behavior under two different market structures: pure (perfect) competition and pure monopoly.

These represent the two extremes of the market structure spectrum. While rarely found in their pure forms in the real world, they serve as essential benchmarks for understanding pricing decisions. Throughout this analysis, we assume that firms are guided by the objective of profit maximization.

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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. No individual buyer or seller has any influence over the market price.

Characteristics of Perfect Competition

• Large Number of Buyers and Sellers: The market consists of numerous participants, each too small to affect the market price individually.
• Homogeneous Product: All firms sell identical (standardized) products. Consumers cannot distinguish between products from different sellers.
• Free Entry and Exit: There are no barriers preventing new firms from entering the market or existing firms from leaving.
• Perfect Information: All market participants have complete knowledge about prices, product quality, and production methods.
• Price Takers: Individual firms accept the market price as given. They can sell any quantity at the prevailing price but nothing above it.

The Demand Curve Facing a Competitive Firm

Because a perfectly competitive firm can sell any amount at the market price, but nothing at a higher price, the demand curve facing an individual firm is perfectly horizontal (elastic) at the market price level.

Price and Output Determination

Managers of firms in a perfectly competitive market face a horizontal demand curve and have no control over the price. They simply choose the profit-maximizing output level. The profit-maximizing rule is straightforward:

1. Produce output where Marginal Revenue (MR) equals Marginal Cost (MC)
2. Since P = MR in perfect competition, this becomes P = MC
3. The firm's supply curve is its marginal cost curve (above average variable cost)

Short-Run vs Long-Run Equilibrium

Short Run: Firms may earn economic profits, normal profits, or losses depending on the relationship between price and average total cost.

Long Run: Free entry and exit ensure that economic profits are competed away:

• If firms earn profits → New firms enter → Supply increases → Price falls
• If firms incur losses → Some firms exit → Supply decreases → Price rises
• Long-run equilibrium: P = MC = Minimum ATC (zero economic profit)

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Pure Monopoly

A monopoly exists when there is only one seller in the market. The monopolist is the industry. Unlike competitive firms, a monopolist faces the entire market demand curve and has significant power to influence price.

Characteristics of Pure Monopoly

• Single Seller: One firm constitutes the entire industry
• No Close Substitutes: The product has no good alternatives available
• High Barriers to Entry: Other firms cannot enter the market due to legal, technological, or resource barriers
• Price Maker: The monopolist has power to set prices by controlling output
• Downward-Sloping Demand: The firm faces the market demand curve

Sources of Monopoly Power

1. Legal Barriers: Patents, copyrights, government licenses, franchises
2. Control of Essential Resources: Exclusive access to key inputs
3. Economies of Scale: Natural monopolies where one firm can serve the market more efficiently
4. Network Effects: Value increases as more people use the product (e.g., social media platforms)

The Monopolist's Demand and Revenue

The monopoly firm faces a downward-sloping demand curve. This has crucial implications:

• To sell more units, the monopolist must lower the price
• The price reduction applies to ALL units sold, not just the additional unit
• Therefore, Marginal Revenue (MR) is less than Price (P)

Price and Output Determination Under Monopoly

The monopolist maximizes profit by following the same basic rule as competitive firms—produce where MR = MC. However, the outcome is very different:

1. Find the profit-maximizing quantity: Where MR = MC
2. Determine the price: Go up to the demand curve at that quantity
3. Calculate profit: (P - ATC) × Q

Monopoly and Market Power

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, it must lower the price because total supply in the market increases to the extent that its output increases.

This trade-off between price and quantity is the essence of monopoly pricing power. The monopolist chooses the combination that maximizes profit.

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Comparison: Competition vs. Monopoly

Characteristic	Perfect Competition	Pure Monopoly
Number of Firms	Many small firms	Single firm
Product	Homogeneous	Unique, no substitutes
Entry Barriers	None	High
Demand Curve	Horizontal (perfectly elastic)	Downward-sloping (market demand)
Price Setting	Price taker (accepts market price)	Price maker (sets price)
MR vs Price	MR = P	MR < P
Profit Max Rule	P = MC	MR = MC (then find P from demand)
Long-Run Profit	Zero economic profit	Can maintain economic profit
Output Level	Higher	Lower (restricted)
Price Level	Lower (equals MC)	Higher (above MC)
Consumer Surplus	Maximized	Reduced (transferred to firm)
Efficiency	Allocatively & productively efficient	Deadweight loss exists

The Welfare Impact

Compared to perfect competition, monopoly results in:

• Higher prices for consumers
• Lower output produced
• Deadweight loss to society (loss of economic efficiency)
• Transfer of surplus from consumers to the monopolist

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Real-World Relevance

Why Study These Extreme Cases?

The assumptions underlying perfect competition are very restrictive. Few markets have many small sellers, easy entry and exit, and undifferentiated products. Similarly, pure monopolies are rare due to antitrust laws and competitive pressures.

However, these models are invaluable because:

1. Benchmarking: Perfect competition provides the ideal outcome against which other market structures can be compared
2. Policy Guidance: If competition produces better outcomes, regulation should aim to increase competition
3. Understanding Extremes: Real markets (oligopoly, monopolistic competition) lie between these extremes
4. Consumer Surplus Analysis: We can measure welfare losses from market power

Markets Approaching These Models

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Conclusion

Understanding the pricing behavior under perfect competition and monopoly provides essential foundations for managerial economics. While these pure forms rarely exist, they establish important benchmarks:

The goal of competition policy and regulation is to move markets toward the competitive ideal, generating lower prices, higher output, and greater consumer welfare. When competition is not feasible (as in natural monopolies), regulation aims to produce competitive-like outcomes.