Transcript Money & Central Banks

Perfect Competition, Profits,
Supply
KW Chapter 9
Costs and Supply Decisions
• How much should a firm supply?
– Firms and their managers should attempt to
maximize profits (Revenues – Costs)
– Select a pricing strategy that induces a
demand for a product that generates highest
revenue relative to the cost of production of
that level of supply.
• Profits depends on response of revenues
to changes in production quantities.
Perfect Competition/ Price Taking
• We think of some markets as
characterized by perfect competition
– In competitive markets, no firm has the market
power to set their own price.
• Firms in perfectly competitive markets take
their price as given.
• Demand curve for an individual producer
of a commodity is perfectly elastic.
Characteristics of Competitive
Markets
•
•
•
•
Non-differentiated goods
Large number of firms
All firms are small relative to the market
Free entry and exit.
Name some uncompetitive
markets
Name some competitive
markets in HK
Revenues and Perfect Competition
• Revenues = Price * Quantity
• Average Revenue = Price
• Marginal Revenue is the extra revenue
generated by selling an extra good.
– If production by a firm doesn’t shift the price,
marginal revenue is the price.
Accounting vs. Economic Profits
• Profits are revenues less costs.
• Economic profits are revenues less explicit and
implicit costs.
– Economic profits attract competition so they typically
don’t last.
• Accountants do not fully incorporate all implicit
costs including cost of equity capital or owner’s
contribution of time or expertise.
– Accountants do incorporate some implicit costs (such
as depreciation) into their profit& loss statements.
Profit Maximization: Short Run
• In the short-run, firm may only have a limited
number of avenues along which they may
vary production.
• Cost of producing each good is likely to
increase. But as long as the extra revenue
that the good brings in exceeds the extra
cost, it will be profitable to produce it.
• Maximize profits by producing up to that
point that price is equal to marginal cost.
Beyond that, producing more goods only
subtracts from profits.
Increase Production until marginal
cost reaches the price level.
P
MC
P
ATC
Q*
Q
Revenues are price × quantity
MC
P
P
ATC
Revenues
Q*
Q
Profits are Revenues - Costs
MC
P
P
Profits
ATC
Costs
Q*
Q
Profit Maximization: Price is 80
Output
(Loaves)
0.00
Average
Total
Costs
10.00
115
20.00
75
30.00
68
40.00
70
50.00
75
60.00
82
Marginal
Marginal
Costs Revenues Revenues Profits
0.00
-1000.00
15.00
80.00
800.00
-350.00
35.00
80.00
1600.00
100.00
55.00
80.00
2400.00
350.00
75.00
80.00
3200.00
400.00
95.00
80.00
4000.00
250.00
115.00
80.00
4800.00
-100.00
What if prices drop?
MC
P
P
Breakeven point
ATC
-Profits
P'
Costs
Q**
Q
• The average total cost of production (when marginal
cost equals price) is above the new lower price.
– If the firm sets production at a level such that
price equals marginal cost, but that is the best
they can do in the short run.
– Firms only decision is to vary production costs
along those dimensions that are available.
• Should the firm shut down?
– No. The firm has paid costs which cannot be
retrieved [SUNK COSTS]. Since the firm cannot
change this, they should ignore these sunk costs
in making their marginal decision.
– As long as prices exceeds variable costs,
produce.
Profit Maximization: Price is 60
Output
(Loaves)
0.00
Average
Total
Costs
10.00
115
20.00
75
30.00
68
40.00
70
50.00
75
60.00
82
Marginal
Marginal
Costs Revenues Revenues Profits
0.00
-1000.00
15.00
60.00
600.00
-550.00
35.00
60.00
1200.00
-300.00
55.00
60.00
1800.00
-250.00
75.00
60.00
2400.00
-400.00
95.00
60.00
3000.00
-750.00
115.00
60.00
3600.00
-1300.00
When should the firm stop
production in the short-run?
MC
P
Breakeven point
AVC
ATC
P
P'
Dropout point
Q**
Q
Adjustment in the Long Run
• In the longer run, firms are able to adjust the
size of their plant. (adjust the number of
machines in the factory, adjust the number of oil
rigs).
• If profits are positive. Firms will seek to build
new equipment as they compete for profits.
• If profits are negative, firms will shut down
equipment and sell it, or possibly go out of
business.
– Firms will adjust their physical plant until they are
making profits again.
Profit maximization and the supply
curve
• In the short-run, firms produce up to that point
where price equal marginal cost.
• Supply curve is the sum of the supply curves of
the different firms in the market.
• In the long-run, capacity will be adjusted to the
point where profits are zero (i.e. where marginal
cost equals average total cost).
• Long run ATC curve is collection of points where
MC = ATC and is the long-run supply curve.
Firm Level Supply Curve:
Short Run
P
SFirm 1
SR ATC
P*
MC
Output
In the short run, MC curve is the relationship between firm price and production
Firm Level Supply Curve:
Short Run
P
SFirm 2
SR ATC
P*
MC
Output
Industry Level Supply Curve:
Short Run
P
SFirm 1 +SFirm 2 +SFirm 3
SIndustry
Output
In the short run, the sum of the MC curves is the relationship between price and industry
production
Short Run Response to Increase in Demand
Increase Variable Inputs
P
D
SIndustry
2
P**
1
P*
D'
Q*
Q**
Output
Firm Level Supply Curve:
Short Run
P
2
P**
SFirm 1
SR ATC
1
P*
MC
q*
q**
Output
In the short run, MC curve is the relationship between firm price and production
Short-run profits attract new
entrants
P
Profits
2
P**
SFirm 1
Profits
SR ATC
MC
q*
q**
Output
In the short run, MC curve is the relationship between firm price and production
New Entrants in the Long Run
Supply Increases and Price Drops
P
D
SIndustry +SFirm N+ 1
2
P**
3
P**
1
P*
D'
Q* Q** Q***
Output
Firm Level Response to New
Entrants: Reduce Output
P
2
P**
3
SFirm 1
SR ATC
P***
1
P*
MC
q* q*** q**
Output
In the short run, MC curve is the relationship between firm price and production
New Entrants as Long as Profits at MES
Supply Increases and Price Drops
P
D
+SFirm N+ 1 +SFirm N+ J
SIndustry
2
P**
3
P**
P*
1
4
D'
Q* Q** Q*** Q**** Output
Firm Level Response to New
Entrants: Reduce Output
P
2
P**
3
P***
SFirm 1
SR ATC
1,4
P*
MC
q* q*** q**
Output
In the short run, MC curve is the relationship between firm price and production
Long Run, Supply is Flat along MES of New
Entrants
P
D
SIndustry
+SIndustry
2
P**
P**
P*
1
4
D'
SLR
Q* Q** Q*** Q****Output
Long Run Supply Curve
• If all firms are exactly the same, then new
firms have same MES as old firms and
supply curve is flat.
• In some cases, like oil drilling, new firms
may have higher MES than old firms and
supply curve is upward sloping.
• Long run supply curve is flatter, more
elastic than short-term supply curve.
Long Run Equilibrium
• Firms are making zero profits.
• Firms will be producing at their minimum
efficient scale and at a minimum of ATC
Learning Outcomes
Students should be able to
• Characterize a perfectly competitive market.
• Calculate total revenue, marginal revenue and
profit for a firm in a competitive market.
• Describe the supply curve in a competitive
market in both the short and long run.
• Explain economies of scale and compare the
effects of demand on price in a competitive
market with increasing, decreasing, and constant
costs.