Transcript Chapter 14 - Powerpoint

The Production Decisions of
Competitive Firms
Alternative market structures:
• perfect competition
• monopolistic competition
• oligopoly
• monopoly
Crucial elements in distinguishing
between alternative market structures:
• The number of buyers and sellers.
• The degree of product homogeneity.
• Knowledge of market prices and
product availability.
• Firms’ ease of entry into, and exit
from, the industry.
Attributes of a market in which there
is perfect competition:
1. There are large numbers of buyers and sellers.
2. The product is homogeneous; buyers view the
units sold by all sellers as being perfect substitutes
(functionally identical).
3. There is freedom of entry and exit by firms.
4. There is complete information regarding prices,
technology and profit opportunities.
5. The objective of each firm is to maximize its
profits.
Each competitive firm is a price taker in that
it will take the price as being given.
Explanation:
If a firm tries to charge a higher price, buyers
will go to other sellers who they know are
willing to sell the same product.
A firm could sell at a lower price. However,
since it can sell all units at the market price,
it will not do so, since the result would be
lower profits.
Relationship between a firm’s demand
curve and the market
P
P
Market
S
P0
individual
firm
P0
d
D
50,000
Q
100
200
q
A price-taking firm faces a horizontal demand curve.
Total Revenue, TR, is the money receipts
generated from a given level of output, Q.
Example:
Suppose a firm sells 100 units at $20 each and
50 units at $10 each.
Total revenue would equal $2,500.
$2,500 = $20 • 100 + $10 • 50
Special case: When a firm sells all units of output,
Q, at the same price, P, total revenue will be
TR = P • Q.
Average Revenue, AR, is the
TR
revenue per unit of output; AR 
Q
When all units are sold at the same price,
AR = P.
TR P  Q
AR 

P
Q
Q
Marginal Revenue, MR, is the change in
total revenue per unit of change in output;
TR
MR 
Q
When all units are sold at the same price,
MR = P.
TR P  Q
MR 

P
Q
Q
In summary, when a firm is a
price-taker, P = MR = AR.
The above relationships are illustrated in the following
example:
Q
P
TR
units
$/unit $
$/unit $/unit
0
1
2
3
2
2
2
2
--2
2
2
0
2
4
6
MR AR
--2
2
2
Choices faced by a firm:
Short-run decisions:
• quantity of output
• quantity of each variable input
• shutdown decision
Long-run decisions:
• quantity of output
• quantity of each and every input
• entry and exit decision
What about the choice of price?
Consider a perfectly competitive firm operating in a
market where the equilibrium price is $13.
Given the cost structure shown, what level of output
will the firm choose?
Q TVC
units
$
0
0
1
10
2
16
3
24
4
34
5
46
6
60
7
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
13
13
13
13
13
13
13
13
TR
$
0
13
26
39
52
65
78
91
Profits
$
-10
-7
0
5
8
9
8
4
Consider a perfectly competitive firm operating in a
market where the equilibrium price is $13.
Given the cost structure shown, what level of output
will the profit maximizing firm choose?
Q TVC
units
$
0
0
1
10
2
16
3
24
4
34
5
46
6
60
7
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
13
13
13
13
13
13
13
13
TR
$
0
13
26
39
52
65
78
91
Profits are largest at 5 units of output.
Profits
$
-10
-7
0
5
8
9
8
4
The profit maximizing level of output can be
inferred using marginal analysis.
For the units of Q up to the 5th, MR > MC.
Beyond the fifth unit, MR < MC.
Example 1
20
AC
18
TVC
$
0
10
16
24
34
46
60
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
13
13
13
13
13
13
13
13
TR
$
0
13
26
39
52
65
78
91
Profits
$
-10
-7
0
5
8
9
8
4
MC
16
dollars per unit
Q
units
0
1
2
3
4
5
6
7
P = MR
14
12
10
8
AVC
6
4
2
0
1
2
3
4
output
5
6
7
Suppose the cost structure is unchanged but the
market price is $10.
Q
units
0
1
2
3
4
5
6
7
TVC
$
0
10
16
24
34
46
60
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
10
10
10
10
10
10
10
TR
$
0
10
20
30
40
50
60
70
Profits
$
-10
-10
-6
-4
-4
-6
-10
-17
Case of the market price equaling $10.
Q
units
0
1
2
3
4
5
6
7
TVC
$
0
10
16
24
34
46
60
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
10
10
10
10
10
10
10
TR
$
0
10
20
30
40
50
60
70
Profits
$
-10
-10
-6
-4
-4
-6
-10
-17
With P = $10, MC equals MR when output is 4 units.
Check whether an output of 4 units maximizes profits.
Case of the market price equaling $10.
Q
units
0
1
2
3
4
5
6
7
TVC
$
0
10
16
24
34
46
60
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
10
10
10
10
10
10
10
TR
$
0
10
20
30
40
50
60
70
Profits
$
-10
-10
-6
-4
-4
-6
-10
-17
Note: At the optimal level of output (Q = 4), profits are
negative.
Why doesn’t the firm shut down, i.e., produce no output?
The loss is smaller (profits are larger) if the firm produces
4 units.
What if P=6?
Q
units
0
1
2
3
4
5
6
7
TVC
$
0
10
16
24
34
46
60
77
TC
$
10
20
26
34
44
56
70
87
AVC
$/unit
10
8
8
8.5
9.2
10
11
AC
$/unit
20
13
11.33
11
11.2
11.67
12.43
MC
$/unit
10
6
8
10
12
14
17
P = MR
$/unit
6
6
6
6
6
6
6
6
TR
$
0
6
12
18
24
30
36
42
Profits
$
-10
-14
-14
-16
-20
-26
-34
-45
Example 3
The firm would make
larger profits (here have
a smaller loss) by
shutting down and not
producing any output.
20
AC
18
MC
dollars per unit
16
14
12
10
8
AVC
6
P = MR
4
2
0
1
2
3
4
output
5
6
7
Measuring Profits and Costs Graphically
TR  Q  P
 50  $2
 $100
  TR  TC
 $100  $65
 $35
MC
2.00
1.30
TC  Q  ATC
 50  $1.30
 $65
P = $2.00
2.50
1.50
ATC
1.00
AVC
.50
10
20
30
40
50
Q = 50
Measuring Profits and Costs Graphically
  TR  TC
 Q  P  Q  ATC
 Q  ( P  ATC )
 50  ($2  $1.30)
 50  ($0.70)
 $35
FC  Q  AFC
 Q  ( ATC  AVC )
 50  ($1.30  $1.00)
 $15
P = $2.00
2.50
MC
2.00
1.50
$35
1.00
$15
1.30
ATC
AVC
.50
10
20
30
40
50
Q = 50
Measuring Profits and Costs Graphically (P=$1.00)
TR  Q  P
 30  $1
 $30
P 2.50
TC  Q  ATC
 30  $1.20
 $36
MC
2.00
AC
1.50
P = $1.00
1.20 1.00
  TR  TC
 $30  $36
  $6
0.70
AVC
.50
10
20
30
40
50
Q
Measuring Profits and Costs Graphically
  TR  TC
 Q  P  Q  ATC
P 2.50
 Q  ( P  ATC )
 30  ($1  $1.20)
 30  ( $0.20)
  $6
MC
2.00
AC
1.50
P = $1.00
1.20 1.00
FC  Q  AFC
0.70
 Q  ( ATC  AVC )
 30  ($1.20  $07.0)
 $15
AVC
.50
10
20
30
40
50
Q
Condition for profit maximization in the
short-run:
A firm will produce the level of output where
MR = MC as long as it is not more profitable for the firm
to shut down (i.e., not produce any output).
Short-run profits if the firm shuts down:
Π0 = TR - TC = (TR - VC) - FC = (0 - 0) - FC = - FC
Short-run profits if the firm produces:
Π1 = TR - TC = (TR - VC) - FC = (Q ·P - Q ·AVC) - FC
= Q · (P - AVC) - FC
Shut-down Condition:
It will be more profitable for the firm to produce
in the short-run (rather than shut down) only if
Π1 > Π0 or, equivalently, TR > VC.
When all units are sold at the same price, an
equivalent expressions is P > AVC.
Conversely, it will be more profitable for the firm
to shut down (rather than produce) if TR < VC or,
equivalently, P < AVC.
$ per
unit
MC
P1
P2
AVC
P4
P5
q5 q4
q2
q1
q
Restatement of profit maximizing firm’s
short-run output decision rule:
A firm will choose to shut down if P is less than
the minimum AVC. Otherwise, the firm will
produce the output for which the associated
marginal cost is equal to marginal revenue, which
equals price for a competitive firm.
Basic insights:
1. Fixed costs are irrelevant in the
short-run shutdown decision, as
well as in the decision of how many
units to produce.
2. A firm’s MC curve above AVC is its
short-run supply curve.
S
$ per
unit
MC
P1
P2
AVC
P4
P5
q5 q4
q2
q1
q
$ per
unit
MC
P1
P3
AC
P2
AVC
P4
P5
AFC
q5 q4 q3 q2
q1
q
Choices faced by a firm:
Short-run decisions:
• quantity of output
• quantity of each variable input
• shutdown decision
Long-run decisions:
• quantity of output
• quantity of each and every input
• entry and exit decision
Attributes of a market in which there
is perfect competition:
1. There are large numbers of buyers and sellers.
2. The product is homogeneous; buyers view the
units sold by all sellers as being perfect substitutes
(functionally identical).
3. There is freedom of entry and exit by firms.
4. There is complete information regarding
prices, technology and profit opportunities.
5. The objective of each firm is to maximize its
profits.
p
MC
AC
P0
q0
Profit Maximization
in the Long-run
q
A firm will choose to produce the level of output where the long-run marginal
cost of that output equals the market price; the level of output will be such that
LRMC = P, provided that profits are not negative.
Entry-Exit Decision:
• If profits are positive, other firms will enter the market.
• If profits are negative, a firm will exit the market.
Suppose that all firms have an identical (long-run) cost
structure as shown in figure 1.
Demand is shown by D in figure 2.
Market supply is initially Sa which reflects a given
number of firms currently in the industry.
Figure 1
p
p
MC
Figure 2
S1
a
D
S
S 2 Sb
AC
P0
p1
P2
P5
P0
p1
P2
P1
q5
q0
q
Q0
Q5
Q
Figure 1
p
MC
AC
P1
p
Figure 2
D
Sb
P5
q5
q
Q5
Q
An equilibrium exists when economic forces are in balance so that
the values of economics variables have no tendency to change.
Conditions for a competitive market to be in long-run
equilibrium:
1. Each firm produces the level of output where the MC of the last
unit produced equals the market price; P = MC.
2. Each firm earns zero economic profits (the level of output is
such that P = AC).
The market long-run supply curve shows the relation between
price and total quantity supplied for the case where the market is in
long-run equilibrium.
To construct the L-R supply curve, we hypothesize shifts in demand
and see how long-run equilibrium price and quantity adjust.
p
p
MC
AC
P2
P2
P1
P1
q1 q2
q
D2
Sa
D1
Sb
SLR
Q1 Q2
Q3
Q
If changes in industry output do not result in changes in input prices,
the long-run market supply curve will be horizontal (perfectly elastic).
Because firms can enter and exit in the long-run,
the long-run supply curve typically is more
elastic than the short-run supply curve.
D2
D1
SSR
P2
P1
SLR
Q1
Q2
Q3
Reasons why the long-run supply
curve might slope upward:
• Firms may have different costs.
• Some resources used in production
may be limited in supply.
MC’
p
MC AC’
p
AC
P2
D2
Sa
D1
Sc
P2
P4
P1
P4
P1
q
Q1 Q2 Q4
Q3
Q