Chapter 11 Managerial Decisions in Competitive Markets

1. Chapter 11Managerial Decisions in Competitive Markets

2. Learning Objectives • Discuss 3 characteristics of perfectly competitive markets • Explain why the demand curve facing a perfectly competitive firm is perfectly elastic and serves as the firm’s marginal revenue curve • Find short‐run profit‐maximizing output, derive firm and industry supply curves, and identify producer surplus • Explain characteristics of long‐run competitive equilibrium for a firm, derive long‐run industry supply, and identify economic rent and producer surplus • Find the profit‐maximizing level of a variable input • Employ empirically estimated values of market price, average variable cost, and marginal cost to calculate profit‐maximizing output and profit

3. Perfect Competition • Firms are price-takers • Each produces only a very small portion of total market or industry output • All firms produce a homogeneous product • Entry into & exit from the market is unrestricted

4. Demand for a Competitive Price-Taker • Demand curve is horizontal at price determined by intersection of market demand & supply • Perfectly elastic • Marginal revenue equals price • Demand curve is also marginal revenue curve (D = MR) • Can sell all they want at the market price • Each additional unit of sales adds to total revenue an amount equal to price

5. S P0 P0 D = MR D Q0 Demand for a Competitive Price-Taking Firm (Figure 11.2) Price (dollars) Price (dollars) 0 0 Quantity Quantity Panel B – Demand curve facing a price-taker Panel A – Market

6. Profit-Maximization in the Short Run • In the short run, managers must make two decisions: • Produce or shut down? • If shut down, produce no output and hires no variable inputs • If shut down, firm loses amount equal to TFC • If produce, what is the optimal output level? • If firm does produce, then how much? • Produce amount that maximizes economic profit Profit = π = TR - TC

7. Profit-Maximization in the Short Run • In the short run, the firm incurs costs that are: • Unavoidable and must be paid even if output is zero • Variable costs that are avoidable if the firm chooses to shut down • In making the decision to produce or shut down, the firm considers only the (avoidable) variable costs & ignores fixed costs

8. Profit Margin (or Average Profit) • Level of output that maximizes total profit occurs at a higher level than the output that maximizes profit margin (& average profit) • Managers should ignore profit margin (average profit) when making optimal decisions

9. Short-Run Output Decision • Firm will produce output where P = SMCas long as: • Total revenue ≥ total avoidable cost or total variable cost (TR  TVC) • Equivalently, the firm should produce if P  AVC

10. Short-Run Output Decision • The firm will shut down if: • Total revenue cannot cover total avoidable cost (TR < TVC) or, equivalently, P  AVC • Produce zero output • Lose only total fixed costs • Shutdown price is minimum AVC

11. Fixed, Sunk,& Average Costs • Fixed, sunk, & average costs are irrelevant in the production decision • Fixed costs have no effect on marginal cost or minimum average variable cost—thus optimal level of output is unaffected • Sunk costs are forever unrecoverable and cannot affect current or future decisions • Only marginal costs, not average costs, matter for the optimal level of output

12. Profit Maximization: P = $36 (Figure 11.3)

13. Profit Maximization: P = $36 (Figure 11.3)

14. Profit Maximization: P = $36 (Figure 11.4) Break-even point Panel A: Total revenue & total cost Break-even point Panel B: Profit curve when P = $36

15. Total cost = $17 x 300 = $5,100 Short-Run Loss Minimization: P = $10.50 (Figure 11.5) Profit = $3,150 - $5,100 = -$1,950 Total revenue = $10.50 x 300 = $3,150

16. Summary of Short-Run Output Decision • AVCtells whether to produce • Shut down if price falls below minimum AVC • SMC tells how much to produce • If P  minimum AVC, produce output at which P = SMC • ATC tells how much profit/loss if produce π = (P – ATC)Q

17. Short-Run Supply Curves • For an individual price-taking firm • Portion of firm’s marginal cost curve above minimum AVC • For prices below minimum AVC, quantity supplied is zero • For a competitive industry • Horizontal sum of supply curves of all individual firms; always upward sloping • Supply prices give marginal costs of production for every firm

18. Short-Run Producer Surplus • Short-run producer surplus is the amount by which TR exceeds TVC • The area above the short-run supply curve that is below market price over the range of output supplied • Exceeds economic profit by the amount of TFC

19. Computing Short-Run Producer Surplus (Figure 11.6)

20. Short-Run Firm & Industry Supply (Figure 11.6)

21. Long-Run Profit-Maximizing Equilibrium (Figure 11.7) Profit = ($17 - $12) x 240 = $1,200

22. Long-Run Competitive Equilibrium • All firms are in profit-maximizing equilibrium (P = LMC) • Occurs because of entry/exit of firms in/out of industry • Market adjusts so P = LMC = LAC

23. Long-Run Competitive Equilibrium (Figure 11.8)

24. Long-Run Industry Supply • Long-run industry supply curve can be flat (perfectly elastic) or upward sloping • Depends on whether constant cost industry or increasing cost industry • Economic profit is zero for all points on the long-run industry supply curve for both types of industries

25. Long-Run Industry Supply • Constant cost industry • As industry output expands, input prices remain constant, & minimum LAC is unchanged • P = minimum LAC, so curve is horizontal (perfectly elastic) • Increasing cost industry • As industry output expands, input prices rise, & minimum LAC rises • Long-run supply price rises & curve is upward sloping

26. Long-Run Industry Supply for a Constant Cost Industry (Figure 11.9)

27. Long-Run Industry Supply for an Increasing Cost Industry (Figure 11.10) Firm’s output

28. Economic Rent • Payment to the owner of a scarce, superior resource in excess of the resource’s opportunity cost • In long-run competitive equilibrium firms that employ such resources earn zero economic profit • Potential economic profit is paid to the resource as economic rent • In increasing cost industries, all long-run producer surplus is paid to resource suppliers as economic rent

29. Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11)

30. Profit-Maximizing Input Usage • Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

31. Profit-Maximizing Input Usage • Marginal revenue product (MRP) • MRP of an additional unit of a variable input is the additional revenue from hiring one more unit of the input • If choose to produce: • If the MRPof an additional unit of input is greater than the price of input, that unit should be hired • Employ amount of input where MRP= input price

32. Profit-Maximizing Input Usage • Average revenue product (ARP) • Average revenue per worker • Shut down in short run if ARP < MRP • WhenARP < MRP, TR < TVC

33. Profit-Maximizing Labor Usage (Figure 11.12)

34. Implementing the Profit-Maximizing Output Decision • Step 1: Forecast product price • Use statistical techniques from Chapter 7 • Step 2: Estimate AVC& SMC • AVC = a + bQ + cQ2 • SMC = a + 2bQ + 3cQ2

35. Implementing the Profit-Maximizing Output Decision • Step 3: Check shutdown rule • If P AVCmin then produce • If P < AVCmin then shut down • To find AVCmin substitute Qmin into AVC equation

36. Implementing the Profit-Maximizing Output Decision • Step 4: If P  AVCmin, find output where P = SMC • Set forecasted price equal to estimated marginal cost & solve for Q* P = a + 2bQ* + 3cQ*2

37. Implementing the Profit-Maximizing Output Decision • Step 5: Compute profit or loss • Profit = TR – TC = P x Q* - AVC x Q* - TFC = (P – AVC)Q* - TFC • IfP < AVCmin, firm shuts down & profit is -TFC

38. Profit & Loss at Beau Apparel (Figure 11.13)

39. Profit & Loss at Beau Apparel (Figure 11.13)

40. Summary • Perfect competitors are price-takers, produce homogenous output, and have no barriers to entry • The demand curve for a perfectly competitive firm is perfectly elastic (or horizontal) at the market determined equilibrium price, and marginal revenue equals price • Managers make two decisions in the short run: (1) produce or shut down, and (2) if produce, how much to produce • When positive profit is possible, profit is maximized at the output where P = SMC • When market price falls below minimum AVCthe firm shuts down and produces nothing, losing only TFC

41. Summary • In long-run competitive equilibrium, all firms are in profit-maximizing equilibrium (P = LMC) • No incentive for firms to enter or exit the industry because economic profit is zero (P = LAC) • Choosing either output or input usage leads to the same optimal output decision and profit level • Five steps to find the profit-maximizing rate of production and the level of profit for a competitive firm: • Forecast the price of the product • Estimate average variable cost and marginal cost • Check the shutdown rule • If P ≥min AVC find the output level where P = SMC • Compute profit or loss