Transcript Chapter 11

Chapter 11: Managerial
Decisions in Competitive Markets
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
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
11-2
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
11-3
Demand for a Competitive
Price-Taking Firm (Figure 11.2)
Price (dollars)
Price (dollars)
S
P0
P0
D = MR
D
0
Q0
Quantity
Panel A –
Market
0
Quantity
Panel B – Demand curve
facing a price-taker
11-4
Profit-Maximization in the
Short Run
•
In the short run, managers must make two
decisions:
1. Produce or shut down?

If shut down, produce no output and hires no variable
inputs

If shut down, firm loses amount equal to TFC
2. 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
11-5
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
11-6
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
 ( P  ATC )Q
Average profit  
Q
Q
 P  ATC  Profit margin
11-7
Short-Run Output Decision
• Firm will produce output where P = SMC
as long as:
• Total revenue ≥ total avoidable cost or total
variable cost (TR  TVC)
• Equivalently, the firm should produce if
P  AVC
11-8
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
11-9
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
11-10
Profit Maximization: P = $36
(Figure 11.3)
11-11
Profit Maximization: P = $36
(Figure 11.3)
11-12
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
11-13
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)
Profitcost
= $3,150
Total
= $17 -x$5,100
300
= -$1,950
= $5,100
Total revenue = $10.50 x 300
= $3,150
11-14
Summary of Short-Run
Output Decision
• AVC tells 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
11-15
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
11-16
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
11-17
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
11-20
Long-Run Cost
Figure 10.8 illustrates economies and diseconomies of scale.
11-21
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)
Profit = ($17 - $12) x 240
= $1,200
11-22
Long-Run Competitive Equilibrium
(Figure 11.8)
11-23
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
11-24
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
11-25
Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)
11-26
Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)
Firm’s output
11-27
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
11-28
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
TR
MRP 
 P  MP
L
• If choose to produce:
• If the MRP of 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
11-31
Profit-Maximizing Input Usage
• Average revenue product (ARP)
• Average revenue per worker
TR
ARP 
 P  AP
L
• Shut down in short run if ARP < MRP
• When ARP < MRP, TR < TVC
11-32
Profit-Maximizing Input Usage
• Hire workers (L*) until MRP = w
• At L* TVC = L* w
• At L* TR = ARP * L*
11-33
Profit-Maximizing Labor Usage
(Figure 11.12)
11-34
Profit-Maximizing Labor Usage
(Figure 11.12)
11-35
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
• TVC = Q(a + bQ + cQ2)
• SMC = a + 2bQ + 3cQ2
11-36
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
Qmin
b

2c
AVC min  a  bQmin  cQ
2
min
11-37
Proof of AVC Min
AVC  a  bQ  cQ 2
AVC
at min
0
Q
AVC
 b  2cQ  0
Q
b
 Qmin 
2c
11-38
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 = SMC
P = a + 2bQ* + 3cQ*2
11-39
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
 b  b  4ac
Q 
2c
2
*
11-40
11-
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
• If P < AVCmin, firm shuts down & profit
is -TFC
11-41
Profit & Loss at Beau Apparel
(Figure 11.13)
11-42
Profit & Loss at Beau Apparel
(Figure 11.13)
11-43