Pricing Policies a Firm Can Choose

Monop­o­lis­tic com­pe­ti­tion: in this mar­ket struc­ture, firms dif­fer­en­ti­ate their prod­ucts, result­ing in a down­ward-slop­ing demand curve for each firm. The mar­ginal rev­enue curve is also down­ward-slop­ing but with a steeper gra­di­ent. Firms will pro­duce at the profit-max­i­miz­ing out­put where MR = MC, earn­ing eco­nomic profit in the short run. How­ever, in the long run, new entrants attracted by eco­nomic profit will increase com­pe­ti­tion, low­er­ing the firm’s demand curve, reduc­ing out­put, and elim­i­nat­ing eco­nomic profit.

Monop­oly: a monop­o­list’s demand curve is the same as the mar­ket’s demand curve, which is down­ward-slop­ing. Monop­o­lists also pro­duce at the profit-max­i­miz­ing out­put where MR = MC. Due to high entry bar­ri­ers, monop­o­lists can main­tain eco­nomic profit in the long run.

Oli­gop­oly: oli­gop­oly mar­kets are unique due to the inter­de­pen­dence of firms’ pric­ing and out­put deci­sions. The best pric­ing strat­egy depends on what we assume about how the firms behave:

Per­fect col­lu­sion: if firms per­fectly col­lude, the entire mar­ket acts like one big monop­oly. Firms col­lude to pro­duce at the level where mar­ket MR = mar­ket MC and charge a high price to max­i­mize and sus­tain long-run profit.

Per­fect com­pe­ti­tion among the firms: if firms act as per­fect com­peti­tors, mar­ket behav­ior is like a per­fectly com­pet­i­tive mar­ket. In the long run, price con­verges to the level of the min­i­mum aver­age cost of pro­duc­tion, and no eco­nomic profit can be made.

How­ever, these are extreme the­o­ret­i­cal mod­els. In prac­tice, firms tend to cheat on col­lu­sive agree­ments, mak­ing the long-run out­come inde­ter­mi­nate. Prices will likely fall between monop­oly and per­fect com­pe­ti­tion prices.

Other oli­gop­oly mod­els include the kinked demand model and the dom­i­nant firm model:

• Kinked Demand Model: Assumes com­peti­tors will match a price decrease but not a price increase. Firms max­i­mize profit where MR = MC, but there is a gap in the mar­ginal rev­enue curve, result­ing in the same opti­mal quan­tity for many cost struc­tures. Firms have lit­tle incen­tive to devi­ate from the pre­vail­ing price.
• Dom­i­nant Firm Model: Assumes one firm has the low­est cost struc­ture and a large mar­ket share. The dom­i­nant firm max­i­mizes prof­its by pro­duc­ing the quan­tity for which its mar­ginal cost equals its mar­ginal rev­enue and charges the price on its firm demand curve for that quan­tity. Other firms in the mar­ket essen­tially take that price as given and pro­duce the quan­tity for which their mar­ginal cost equals that price.