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Class #10 Profit Maximization and Perfect Competition

Class #10 Profit Maximization and Perfect Competition. Fall 2010-11. The Economics of Production. Review… What is the most efficient (least cost) way to produce any given amount of output?

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Class #10 Profit Maximization and Perfect Competition

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  1. Class #10Profit Maximization andPerfect Competition Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  2. The Economics of Production • Review… What is the most efficient (least cost) way to produce any given amount of output? • Budget Constraint – All the combinations of inputs which a firm can buy for a given budget. • Isoquant – All the combinations of input with which a firm can produce a given amount of output. • Technically Efficient (i.e., least cost) production – Choose the combination of inputs so that the contribution to output per dollar spent on an input is equated across inputs (the point where the slope of the Isoquant and the slope of the Budget Constraint are equal). • Expansion Path – What is the most efficient (lowest cost) way of producing any particular amount of production? • Average and Marginal Cost Curves – How costs vary as output changes Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  3. Profit Maximization • Profit = Total Revenues (TR) – Total Costs (TC) • What do we mean by profit? • Economic Profit v. Accounting Profit • Is the assumption of profit maximization reasonable? What else might a firm maximize? • Total sales? • Size? • ?? Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  4. The “Expansion Path” of Efficient Production Capital (Machinery) M W Q TC AC At Pt. A 4 60 50 $1000 $20 At Pt. C 3 50 40 $800 $20 At Pt. D 7.5 75 60 $1500 $25 PM = $100/day 15 PW = $10/day 10 8 Expansion Path D 7.5 Q = 60 4 A 3 C Q = 50 Q = 40 50 60 75 Worker Days Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  5. How Much Would a Manufacturer Pay for Steel? Suppose Consumer Price Per Unit of Output = $10 Mfgr’s Willingness to Pay for Steel This willingness to pay is the mfgr’s DEMAND for steel… …It is the marginal contribution of value to consumers when steel is used in manufacturing. $500 50 $500 $400 40 $400 $300 30 $300 $200 20 $200 $100 10 $100 10 20 30 40 50 60 70 Tons of Steel Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  6. The Relationship BetweenAverage and Marginal Cost $/Q Marginal Cost (MC) Average Cost (AC) Minimum of AC Q Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  7. Total and Marginal Cost $40 $50 $60 $70 $80 $100 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  8. Total Cost Curve $ 6000 5000 4000 3000 Slope of Total Cost Curve = ∆TC/∆Q = Marginal Cost 2000 1000 Q 10 20 70 80 30 50 40 60 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  9. Demand Curve Facing the Firm  Total Revenues Price $150 $140 $90 Quantity 70 10 20 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  10. Total and Marginal Revenue $130 $110 $90 $70 $50 $30 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  11. Total Revenue Curve $ 6000 5000 Slope of Total Revenue Curve = ∆TR/∆Q = Marginal Revenue 4000 3000 2000 1000 Q 10 20 70 80 30 50 40 60 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  12. Profit Maximization:Where is Profit (= TR – TC) greatest? Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  13. Total Cost Curve Total Revenue Curve Profit Maximization $ 6000 5000 4000 3000 Profit = Vertical Distance Between Total Revenue and Total Cost Curve 2000 1000 Q 10 20 70 80 30 50 40 60 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  14. What Output Maximizes Profits? …Where MR = MC $40 $130 $50 $110 $60 $90 $70 $70 $80 $50 $100 $30 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  15. Perfect Competition • Attributes of a Perfectly Competitive Market • Each firm is small relative to overall industry. • Each firm produces a homogenous product. • Firms can freely enter or exit the industry. • Implications: • Each firm is a price taker. They can sell as much or as little at the market price as they want without effecting the market price. • There are no “special” costs required to enter or exit the industry. In the long-run, firms will enter if there are profits to be made and will exit if losing money. • Examples • Agriculture Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  16. The Demand Curve Faced By A Price-Taking Firm Price Market Price = $20 What is the Marginal Revenue? Perfect Competition  Price = Marginal Revenue $20 Demand Quantity 10 20 30 50 40 60 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  17. Short-Run Profit Maximization Price Marginal Cost Profits Are Maximized where MR = MC Average Cost Demand MR = P $20 Quantity 10 20 30 50 40 60 qC Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  18. Short-Run Profits for a Price-Taking Firm Price Marginal Cost Profit = TR – TC = qc(pc) – qc(AC) = qc(pc – AC) Average Cost Demand MR = P pC = $20 (pc – AC) = $5 Short-Run Profits = $5*46 = $230 AC = $15 Quantity 10 20 30 50 40 60 qC=46 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  19. Demand MR = P Short-Run Losses in aPerfectly Competitive Industry Price If Price is between AVC and AC, the firm covers its variable costs and is able to cover part of its fixed costs. Marginal Cost Average Cost Short-Run Losses = qc(pc - AC) = 34 * (-1) = -$34 AVC AC = $13 pC = $12 Quantity 10 20 30 50 40 60 qC=34 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  20. pC = $12 Demand MR = P Shutting Down Production in aPerfectly Competitive Industry Price Marginal Cost If Price is below AVC, the firm doesn’t even cover its variable costs. The profit-seeking firm should shut down. Average Cost AVC Quantity 10 20 30 50 40 60 qC=34 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

  21. Short-Run Production (Supply) Curve How much would a firm produce at each price? Price Marginal Cost Average Cost AVC Quantity 10 20 30 50 40 60 Fall 2010-11 KSG API-105A/GSD 5203A – Markets and Market Failure with Cases

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