Transcript Lecture 12

PPA 723: Managerial
Economics
Lecture 12:
Competition in the Short Run
Managerial Economics, Lecture 12: Competition in Short Run
Outline
What Is Perfect Competition?
Competitive Markets in the Short Run
Managerial Economics, Lecture 12: Competition in Short Run
Competition
Perfect competition exists in a market if:
Consumers believe that all firms sell
identical products.
Firms can freely enter and exit the market.
Buyers and sellers know the prices charged
by firms.
Transaction costs are low.
Managerial Economics, Lecture 12: Competition in Short Run
Price Taking
If all 4 conditions hold, each firm is a
price taker, i.e. a firm cannot affect the
market price.
Even if some of conditions don't hold,
firms may be price takers
If entry of new firms is limited but there
are many firms, for example, no firm
can successfully raise its price.
Managerial Economics, Lecture 12: Competition in Short Run
Why Start with Competition?
Competition is a frequently observed
market structure.
As we will see, competition has some
desirable properties, so it is useful to
compare other market structure to
competition.
Managerial Economics, Lecture 12: Competition in Short Run
Profit Maximization
Economists assume that a firm
maximizes its profit.
A competitive firm that did not profit
maximize would lose money and be
driven out of business.
Other objectives, such as sales
maximization, are sometimes
considered—but not here.
Managerial Economics, Lecture 12: Competition in Short Run
Definition of Profit
Profit, , equals a firm's revenues, R,
minus its costs, C:
=R–C
If profit is negative,  < 0, the firm is
said to have a loss.
Managerial Economics, Lecture 12: Competition in Short Run
Business vs. Economic profit
Business profit is revenue minus
business cost (only explicit cost).
Economic profit is revenue minus
economic cost (explicit + implicit cost,
i.e., opportunity cost).
Because explicit cost  economic cost,
business profit  economic profit.
We will always use economic profit.
Managerial Economics, Lecture 12: Competition in Short Run
Example: Your Own Firm
You pay explicit costs (wages,
materials,...).
You do not pay yourself a salary.
You receive a business profit of $70,000
per year.
Your opportunity cost (foregone salary) is
$75,000.
So you have an economic loss of $5,000.
Managerial Economics, Lecture 12: Competition in Short Run
Profit Function
Profit varies with output:
(q) = R(q) - C(q)
So a firm must select the output that
maximizes its profit.
Managerial Economics, Lecture 12: Competition in Short Run
Two Steps to Maximize Profit
 To maximize its profit, any firm (not just a
competitive firm) must answer two questions:
 The output decision: If the firm produces,
what output level, q*, maximizes its profit or
minimizes its loss?
 The shut-down decision: Is it more
profitable to produce q* or to shut down and
produce no output?
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.2 Maximizing Profit
, Profit
*
Profit
D < 0
D > 0
1
0
1
q*
Quantity, q, Units
per day
Managerial Economics, Lecture 12: Competition in Short Run
Maximizing Profit, 1
 The quantity at which  is maximized is
 the quantity at which marginal profit
(extra profit from selling one more unit
of output, D/Dq) equals zero,
 which is the quantity at which the slope
of the profit curve is zero.
Managerial Economics, Lecture 12: Competition in Short Run
Maximizing Profit, 2
The profit function tells us that marginal
profit(q) = MR(q) - MC(q)
So marginal profit equals zero when
MR(q) = MC(q).
For a competitive firm, MR(q) = P.
Thus a competitive firm maximizes profit
by picking the q at which MC(q) = P.
Managerial Economics, Lecture 12: Competition in Short Run
Maximizing Profit, 3
Now consider a firm asking whether to
produce one more unit of output.
If P > MC(q), the firm can increase its
profit by producing another unit.
If P < MC(q), the firm will decrease its
profit by producing another unit.
If P = MC, a firm cannot increase its
profit by altering q.
Managerial Economics,
Competition in Short Run
(a)
Cost, revenue,
Thousand $
Cost, C
4,800
1
2,272
Figure 8.3 How a
Competitive Firm
Maximizes Profit
MR=
8
*
1,846
426
100
0
–100
Revenue
 (q)
* = $426,000
140
284
q , Thousand metric tons of li me per year
(b)
p, $ per ton
10
MC
AC
e
8
p = MR
 * = $426,000
6.50
6
0
140
284
q , Thousand metric tons of lime per year
Managerial Economics, Lecture 12: Competition in Short Run
Equivalent Shut-Down Rules
Rule 1: A firm shuts down only if it can
reduce its loss by doing so.
Rule 2: A firm shuts down only if its
revenue is less than its avoidable cost.
By shutting down, firm eliminates only
avoidable costs:
variable costs
fixed costs that are not sunk
Managerial Economics, Lecture 12: Competition in Short Run
Shutting Down: Example 1
R = $2,000
VC = $1,000
F = $3,000 (sunk)
 = R - VC - F

= $2,000 - $1,000 - $3,000 = $2,000
This firm does not shut down.
Managerial Economics, Lecture 12: Competition in Short Run
Shutting Down, Example 2
R = $500
VC = $1,000
F = $3,000 (sunk)
 = R - VC - F

= $500 - $1,000 - $3,000 = -$3,500
This firm shuts down.
Managerial Economics, Lecture 12: Competition in Short Run
SR Shut-Down Decision
Applying the shut-down rules to the
cost-curve diagram indicates that:
A firm shuts down if P < minimum AVC
In this case, the firm cannot even cover its
variable costs, let alone its fixed costs.
A firm will still operate if P < minimum
AC (but greater than minimum AVC).
The firm has a loss in this case, but it
covers some fixed costs, so its loss would
be larger if it shut down.
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.4 The Short-Run Shutdown Decision
p, $ per ton
MC
AC
b
6.12
6.00
AVC
A = $62,000
5.50
B = $36,000
5.14
5.00
a
0
50
p
e
100
140
q, Thousand metric tons of lime per year
Managerial Economics, Lecture 12: Competition in Short Run
SR Competitive Firm Supply Curve
The output rule (pick q at which P = MC)
and the shut-down rule (shut down if P <
minimum AVC) imply that
The firm’s short-run supply curve is the
MC curve above the minimum of AVC
curve.
We have now gone behind the supply
curve!
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.5 How the Profit-Maximizing Quantity Varies with Price
p, $ per ton
S
e4
8
p4
e3
7
AC
p3
AVC
e2
6
p2
e1
p1
5
MC
0
q 1 = 50
q 2 = 140
q 3 = 215
q 4 = 285
q, Thousand metric tons of lime per year
Managerial Economics, Lecture 12: Competition in Short Run
Factor Prices and the SR Firm Supply Curve
An increase in factor prices causes the
production costs of a firm to rise, shifting
the firm's supply curve to the left.
If all factor prices double, costs double.
If only one factor price rises, costs rise
less than in proportion.
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.6 Effects of an Increase in the Cost of Materials on the
p, $ per ton
Vegetable Oil Supply Curve S2 S1
AVC 2
AVC 1
e2
12
e1
p
8.66
7
MC 2
MC 1
0
100
145
178
q, Hundred metric tons of oil per year
Managerial Economics, Lecture 12: Competition in Short Run
SR Market Supply with Identical Firms
 The market supply curve is the horizontal sum
of the supply curves of all individual firms.
 The maximum number of firms in a market, n, is
fixed in the short run.
 The market supply curve at any price is n times
the supply of an individual firm.
 The larger n (more identical firms), the flatter
(more elastic) the short-run market supply
curve at each price.
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.7 Short-Run Market Supply with Five Identical Lime
Firms
(a) Firm
(b) Market
p, $ per ton
7
p, $ per ton
7
S1
S1
S2
S3
S4
6.47
AVC
6.47
6
6
5
5
S5
MC
0
50
140 175
q, Thousand metric tons
of lime per year
0
50 150 250
100 200
700
Q, Thousand metric tons
of lime per year
Managerial Economics, Lecture 12: Competition in Short Run
SR Market Supply with Differing Firms
If firms face different costs, then
relatively low-cost firms enter first.
The more type of firms there are, the
more kinks there will be in supply curve.
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.8 Short-Run Market Supply with Two Different Lime
p, $ per ton Firms
S2
8
S1
S
7
6
5
0
25 50
100 140 165
215
315
450
q, Q, Thousand metric tons of lime per year
Managerial Economics, Lecture 12: Competition in Short Run
SR Competitive Equilibrium
The intersection of the short-run market
supply curve and the market demand
curve determines the short-run
competitive equilibrium.
If firms have identical costs, the market
equilibrium involves no production if
price falls below minimum AVC.
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.9 Short-Run Competitive Equilibrium in the Lime Market
(a) Firm
(b) Market
p, $ per ton
p, $ per ton
8
8
S1
e1
7
6.97
A
B
S
D1
7
E1
AC
D2
6.20
6
AVC
6
C
5
0
5
e2
q 2 = 50
q 1 = 215
q, Thousand metric tons
of lime per year
0
E2
Q 2 = 250
Q 1 = 1,075
Q, Thousand metric tons
of lime per year
Managerial Economics, Lecture 12: Competition in Short Run
Figure 8.10 Short-Run Effect of a Specific Tax in the Lime Market
(a) Firm
(b) Market
p, $ per unit
p, $ per unit
S 1 + t S1
S+ t
AV C + t
AVC
t
e2
p2
p1
t
E2
p1 + t
S
t
E
e1
t
1
D
MC + t
MC
q2q1
q, Units per year
Q 2 = nq2 Q 1 = nq 1
q, Units per year