Transcript Chapter 14

Chapter 11
Costs and Profit
Maximization Under
Competition
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline
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


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What price to set?
What quantity to produce?
Profits and the average cost curve
Entry, exit, and shutdown decisions
Entry, exit, and industry supply curves
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Introduction
 Every producer must answer three questions:
• What price to set?
• What quantity to produce?
• When to enter and exit the industry?
 This chapter will look at the answers for a
competitive industry.
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What Price to Set?
 In a competitive market, producers are “price
takers”:
• The firm accepts the price that is determined
by the market.
• A firm can sell all its output at market price.
• A firm can’t sell any output at a higher price.
• The firm’s demand is perfectly elastic at
market price.
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What Price to Set?
World Market For Oil
Price
Price
Individual Firm’s Demand
Market
supply
Demand
for one
firm’s oil
$50
Market
demand
82,000,000
Quantity
(barrels)
2
5
10 Quantity
(barrels)
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What Price to Set?
 An industry is competitive when firms don’t have
much influence over the price of their product.
 This is a reasonable assumption when:
• The product being sold is similar across
sellers.
• There are many buyers and sellers, each
small relative to the total market.
• There are many potential sellers.
 Demand is most elastic in the long run.
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Definition
Long run:
the time after all exit or entry has
occurred.
Short run:
the time period before exit or entry can
occur.
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Self-Check
In a perfectly competitive market, a firm will set
its price:
a. Equal to its cost of production.
b. Equal to its costs plus a normal markup.
c. Equal to market price.
Answer: c – Firms in a competitive industry are
price takers, and must accept market price.
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What Quantity to Produce?
 It depends on the objective.
 We assume the objective is to maximize profit.
Profit = π = Total Revenue – Total Cost
 Maximizing profit means maximizing the
difference between total revenue and total costs.
• Total revenue is Price x Quantity.
• Total costs include opportunity costs.
• Must distinguish between many different kinds
of cost (average, marginal, fixed, and so on).
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Definition
Total revenue:
price times quantity sold.
TR = P x Q
Total cost:
cost of producing a given quantity of
output.
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Opportunity Costs
 Total costs include:
• Explicit money costs and
• Implicit opportunity costs, or the costs of
foregone alternatives.
 Output decisions should be based on all costs,
including opportunity costs.
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Definition
Explicit cost:
a cost that requires a money outlay.
Implicit cost:
a cost that does not require an outlay of
money.
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Definition
Accounting profit:
total revenue minus explicit costs.
Economic profit:
total revenue minus total costs including
implicit costs.
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Self-Check
Economic profit is total revenue minus:
a. Explicit costs.
b. Implicit costs.
c. Both explicit and implicit costs.
Answer: c – Economic profit equals total revenue
minus both explicit and implicit costs.
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Definition
Fixed costs:
costs that do not vary with output.
Variable costs:
costs that do vary with output.
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Maximizing Profit
 We can break total costs into two components:
fixed costs and variable costs.
TC = FC + VC
 Profit is the difference between total revenue and
total cost.
 To find the maximum profit, one method is to find
the quantity that maximizes TR − TC.
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Maximizing Profit
 We can use another method of finding the
maximum profit.
 We can compare the increase in revenue from
selling an additional unit (MR) to the increase in
cost from selling an additional unit (MC).
 A firm should keep producing as long
Marginal Revenue (MR) > Marginal Cost (MC)
 The last unit produced should be the one where
MR = MC.
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Definition
Marginal revenue (MR):
the change in total revenue from selling
an additional unit.
MR = TR / Q
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Maximizing Profit
 For a firm in a competitive industry, the demand
curve is perfectly elastic.
 The firm doesn’t need to drop the price to sell
more units.
 Each additional unit can be sold at market price.
 For a firm in a competitive industry, MR = Price.
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Definition
Marginal cost (MC):
the change in total cost from producing
an additional unit.
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Self-Check
A competitive firm will maximize its profit at the
quantity:
a. Where MR = Price.
b. Where MR = MC.
c. Where MC = 0.
Answer: b – a competitive firm will maximize its
profit by producing at the quantity where
marginal revenue (MR) = marginal cost (MC).
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Maximizing Profit
=
Maximizing Profit
P
($/barrel)
$150
At a Quantity of 8,
MR = MC
Profits are maximized
Marginal
cost
100
World
Market
price 50
More profit
More profit
MR = P
0
0
1
2
3
4
5
6
7
8
9
Quantity
10 (barrels)
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Maximizing Profit
 As the price changes, so does the profitmaximizing quantity.
 If price increases, the firm will expand
production.
 Will continue to expand until it is once again
maximizing profit where P = MC.
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Maximizing Profit
P
($/barrel)
$150
As Price increases, the
firm expands production
along its MC curve
Marginal
cost
$100
MR = P
World
Market
price $50
MR = P
0
0
1
2
3
4
5
6
7
8
9
Quantity
10 (barrels)
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Self-Check
If price increases, a firm will:
a. Expand production.
b. Decrease production.
c. Price does not affect how much a firm
produces.
Answer: a – if price increases, a firm will expand
production.
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Definition
Average Cost of Production:
the cost per unit, or the total cost of
producing Q units divided by Q.
AC = TC / Q
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Profits and the Average Cost Curve
 A firm can maximize profits and still have low
profits or even losses.
 It can be useful to show profits in a diagram.
 To do this, we need average cost (cost per unit).
 We can then calculate profitability.
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Profits and the Average Cost Curve
Profit = TR – TC
we can also write
(
Profit =
We then substitute:
TR
Q
– TC
Q
) xQ
TR = P x Q
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Profits and the Average Cost Curve
Profit = TR – TC
we can also write
Profit = P x Q – TC
Q
Q
(
We can also substitute:
) xQ
AC = TC / Q
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Profits and the Average Cost Curve
Profit = TR – TC
we can also write
Profit = P x Q – AC
Q
(
We end up with:
) xQ
Profit = (P – AC) x Q
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Profits and the Average Cost Curve
This formula tells us that Profit is equal to
the average profit per unit (P − AC)
times the number of units sold (Q).
Profit = (P – AC) x Q
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Profits and the Average Cost Curve
With an average cost curve, we can show profits on a graph.
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Maximizing Profit
Price
• Profits are maximized at
MR = MC, where Q = 8
• At Q = 8, AC = $25.75
• Profit = (P – AC) x Q
$100
Marginal
cost
Average
Cost (AC)
MR = P
50
Profit = (50-25.75) x 8 = $194
25.75
0
0
1
2
3
4
5
6
7
8
9
10 Quantity
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Maximizing Profit
Price
• MR = MC doesn’t mean
the firm makes a profit
• Minimum AC is $17
• At any price below $17,
P < AC → Losses
$100
Marginal
cost
Average
Cost (AC)
MR = P
50
Cost = 20
17
Price = 10
0
Loss
0
1
2
3
4
5
6
7
8
9
10 Quantity
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Maximizing Profit
Price
Marginal
cost
$100
The MC curve
crosses the AC curve
at its minimum point
Average
Cost (AC)
50
P = MC < AC
is a loss
P = MC > AC
is a profit
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0
0
1
2
3
4
5
6
7
8
9
10 Quantity
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Self-Check
If a firm produces at the output where MR = MC,
it will always make a profit.
a. True.
b. False.
Answer: b – False; if average cost is greater
than price, the firm will have a loss.
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Entry, Exit, and Shutdown
 Firms seek profits so in the long run:
• Firms will enter the industry when P > AC.
• Firms will exit the industry when P < AC.
 When P = AC, profits are zero and there is no
incentive to enter or exit.
 Zero profits means that the price is just enough
to pay labor and capital their opportunity costs.
 Zero profits really means normal profits.
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Entry, Exit, and Shutdown
 Typically, exit cannot occur immediately.
TC = VC + FC
 In the short run, a firm must pay its fixed costs
whether it is operating or not.
 Fixed costs therefore do not influence decisions
in the short run.
 The firm should shut down immediately only if
TR < VC.
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Entry, Exit, and Shutdown
 If Price is below the minimum of AVC, then the
firm should shut down immediately.
 If Price is above AVC but below AC, then the firm
should continue producing but exit as soon as
possible.
 If Price is at or above AC, the firm should
continue producing where P = MC, or enter if it is
not already in the industry.
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Entry, Exit, and Shutdown
The firm’s entry, exit, and shutdown decisions.
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Entry, Exit, and Industry Supply
 The slope of the supply curve can be explained
by how costs change as industry output changes.
 Supply curves can slope upward, be flat, or in
rare circumstances even slope downward.
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Definition
Increasing Cost Industry:
An industry in which industry costs
increase with greater output; shown with
an upward sloped supply curve.
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Increasing Cost Industry
 Costs rise as industry output increases.
 Greater quantities can only be obtained by using
more expensive methods.
 Any industry that buys a large fraction of the
output of and increasing cost industry will also be
an increasing cost industry.
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Increasing Cost Industry
 Firm 1 – oil is near the surface; lower costs
 Firm2 – oil is located deeper; higher costs
P
Firm 1
MC1
P
$50
Firm 2 MC
2
AC2
P
Industry
SIndustry
AC1
$29
$17
4
q2
6 8 q1
5 7
P < $17 → Q = 0
P = $17 → Q = q1 + q2 = 4
P = $29 → Q = q1 + q2 = 11
P = $50 → Q = q1 + q2 = 15
4
Q
11 15
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Definition
Constant Cost Industry:
An industry in which industry costs do
not change with greater output; shown
with a flat supply curve.
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Constant Cost Industry
A constant cost industry has two characteristics:
1. It meets the conditions for a competitive industry.
• The product is similar across sellers.
• There are many buyers and sellers, each small relative
to the total market.
• There are many potential sellers.
2. It demands only a small share of its major inputs.
• The industry can expand or contract without changing
the prices of its inputs.
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Constant Cost Industry
P
P
Market
Firm
MC
SSA
SSB
B
B
$7.99
$6.99
AC
C LRS
A
C
A
DB
DA
QA QB Q C
Q
qA qB
↑ Market demand → ↑ market price → ↑ profits
↑ profits → Existing firms ↑ q → ↑ Q
↑ profits → Firms enter → Short-run supply shifts right → ↓ P, ↑Q
Profits return to normal
q
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Constant Cost Industry
Implications of a constant cost industry:
 Price is driven down to AC, so profits are driven
down to normal levels.
 Price doesn’t change much because AC doesn’t
change much when the industry expands or
contracts.
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Definition
Decreasing Cost Industry:
An industry in which industry costs
decrease with greater output; shown
with a downward sloped supply curve.
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Decreasing Cost Industry
 Industry clusters can create decreasing cost
industries.
 As the industry grows, suppliers of inputs move
into the area, decreasing costs.
 Dalton Georgia – “Carpet Capital of the World”
 Silicon Valley – Computer technology
 Cost reductions are temporary.
 Once the cluster is established, constant or
increasing costs are the norm.
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Industry Supply Curves
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Self-Check
An industry where the industry costs do not
change with greater output is called a(n):
a. Increasing cost industry.
b. Constant cost industry.
c. Decreasing cost industry.
Answer: b – constant cost industry.
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Takeaway
1. What price to set?
• In a competitive industry, a firm sets its price
at the market price.
2. What quantity to produce?
• To maximize profit, a competitive firm should
produce the quantity that makes P = MC.
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Takeaway
3. When to exit and enter?
• In the short run, the firm should shut down
only if price is less than average variable
cost.
• In the long run, a firm should enter if P > AC
and exit if P < AC.
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Takeaway
 Profit maximization and entry and exit decisions
are the foundation of supply curves.
 In an increasing cost industry, costs rise so
supply curves are upward-sloping.
 In a constant cost industry, costs remain the
same so the long-run supply curve is flat.
 In the rare case of a decreasing cost industry,
costs fall so supply curves are downwardsloping.
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