Transcript IPPTChap011x

Learning Objectives
 Discuss 3 characteristics of perfectly competitive markets
 Explain why the demand curve facing a perfectly
competitive firm is perfectly elastic and serves as the
firm’s marginal revenue curve
 Find short‐run profit‐maximizing output, derive firm and
industry supply curves, and identify producer surplus
 Explain characteristics of long‐run competitive
equilibrium for a firm, derive long‐run industry supply,
and identify economic rent and producer surplus
 Find the profit‐maximizing level of a variable input
 Employ empirically estimated values of market price,
average variable cost, and marginal cost to calculate
11-1
profit‐maximizing output and profit
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
Market Structures
Markets differ according to:
~ the number of firms in the market,
~ the ease with which firms may enter
and leave the market, and
~ the ability of firms in a market to
differentiate their products from those
of their rivals.
11-3
Properties of Monopoly, Oligopoly, Monopolistic
Competition, and Competition
11-4
Zero Long-Run Profit with Free Entry
One implication of the shutdown rule is
that the firm is willing to operate in the long
run even if it is making zero profit.
But how can this be?
Because opportunity cost includes the
value of the next best investment, at a
zero long-run economic profit, the firm is
earning the normal business profit that the
firm could earn by investing elsewhere in
the economy.
11-5
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
11-6
Zero Long-Run Profit When
Entry Is Limited
Figure 9.1
• Rent - a
payment to
the owner of
an input
beyond the
minimum
necessary
for the factor
to be
supplied.
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9-7
The Need to Maximize Profit
• In a competitive market with identical firms
and free entry, if most firms are profit
maximizing, profits are driven to zero at the
long-run equilibrium.
• Any firm that did not maximize profit would
lose money.
Thus, to survive in a competitive market,
a firm must maximize its profit.
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9-8
Measuring Consumer Welfare
Using a Demand Curve
• Consumer welfare from a good is the
benefit a consumer gets from consuming
that good minus what the consumer paid
to buy the good.
• The demand curve reflects a consumer’s
marginal willingness to pay:
– the maximum amount a consumer will spend
for an extra unit
– the marginal value the consumer places on the
last unit of output
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9-9
Figure 9.2 Consumer Surplus
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9-10
Application: Willingness to Pay
and Consumer Surplus on eBay
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9-11
Consumer Surplus
• Consumer surplus (CS) - the monetary
difference between what a consumer is
willing to pay for the quantity of the good
purchased and what the good actually costs.
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9-12
Consumer Surplus (cont.)
• An individual’s consumer surplus is the area
under the demand curve and above the
market price up to the quantity the
consumer buys.
• Market consumer surplus is the area under
the market demand curve above the market
price up to the quantity consumers buy.
Copyright ©2015 Pearson Education, Inc. All rights reserved.
9-13
Effect of a Price Change on
Consumer Surplus
• If the supply curve shifts upward or a
government imposes a new sales tax, the
equilibrium price rises, reducing consumer
surplus.
Copyright ©2015 Pearson Education, Inc. All rights reserved.
9-14
Consumer Surplus and Elasticity
Suppose that two linear demand curves
go through the initial equilibrium, e1. One
demand curve is less elastic than the other
at e1. For which demand curve will a price
increase cause the larger consumer
surplus loss?
11-15
11-16
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 11-17
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
11-18
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
11-19
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
11-20
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
11-21
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
11-22
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
11-23
Profit Maximization: P = $36
(Figure 11.3)
11-24
Profit Maximization: P = $36
(Figure 11.3)
11-25
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
11-26
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)
Profit
= $3,150
Total cost
= $17- $5,100
x 300
= -$1,950
= $5,100
Total revenue = $10.50 x 300
= $3,150
11-27
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
11-28
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
11-29
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
11-30
Computing Short-Run
Producer Surplus (Figure 11.6)
Producer surplus  TR  TVC
 $9 110  $5.55 110
 $990  $610
 $380
Or, equivalently,
Producer surplus = Area of trapezoid edba in Figure 11.6
= Height  Average base
 80  110 
 ($9  $5)  

2


 $380
$380 multiplied by 100 firms  ($380  100)  $38, 000 11-31
Short-Run Firm & Industry Supply
(Figure 11.6)
11-32
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)
Profit = ($17 - $12) x 240
= $1,200
11-33
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
11-34
Long-Run Competitive Equilibrium
(Figure 11.8)
11-35
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
11-36
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
11-37
Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)
11-38
Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)
Firm’s output
11-39
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
11-40
Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)
11-41
Producer Welfare
Producer surplus (PS) - the difference
between the amount for which a good sells
and the minimum amount necessary for
the seller to be willing to produce the
good.
11-42
Measuring Producer Surplus
Using a Supply Curve
The total producer surplus is the area
above the supply curve and below the
market price up to the quantity actually
produced.
PS = R − VC.
Thus, the difference between producer
surplus and profit is fixed cost, F.
11-43
Producer Surplus
11-44
If the estimated supply curve for roses is
linear, how much producer surplus is lost
when the price of roses falls from 30¢ to
21¢ per stem (so that the quantity sold
falls from 1.25 billion to 1.16 billion rose
stems per year)?
11-45
11-46
Competition Maximizes Welfare
One commonly used measure of the
welfare of society, W, is the sum of
consumer surplus plus producer surplus:
W = CS + PS.
11-47
Deadweight Loss (DWL)
Deadweight loss (DWL) - the net
reduction in welfare from a loss of surplus
by one group that is not offset by a gain to
another group from an action that alters a
market equilibrium.
The deadweight loss results because
consumers value extra output by more
than the marginal cost of producing it.
11-48
Why Reducing Output from the Competitive Level Lowers
Welfare
11-49
Why Producing More than the Competitive Output
Lowers Welfare
Increasing output beyond the competitive
level also decreases welfare because the
cost of producing this extra output
exceeds the value consumers place on it.
The reason that competition maximizes
welfare is that price equals marginal cost
at the competitive equilibrium.
Market failure - inefficient production or
consumption, often because a price
exceeds marginal cost.
11-50
Show that increasing output beyond the
competitive level decreases welfare
because the cost of producing this extra
output exceeds the value consumers place
on it.
11-51
Answer
11-52
Policies That Shift Supply and
Demand Curves
Welfare tools are helpful in predicting the
impact of government policies and other
events that alter a competitive equilibrium.
11-53
Policies That Shift Supply and
Demand Curves (cont.)
All government actions affect a
competitive equilibrium in one of two ways.
1. by shifting the supply or demand curve
2. by creating a wedge or gap between price
and marginal cost so that they are not equal,
even though they were in the original
competitive equilibrium
11-54
Policies That Shift Supply and
Demand Curves (cont.)
The two most common types of
government policies that shift the supply
curve are:
~ limits on the number of firms in a market
~ quotas or other limits on the amount of output
that firms may produce
11-55
Profit-Maximizing Input Usage
 Profit-maximizing level of input usage
produces exactly that level of output
that maximizes profit
11-56
Restricting the Number of Firms
Governments, other organizations, and
social pressures limit the number of firms
in at least three ways:
~ explicitly in some markets, such as the one for
taxi service
~ barring some members of society from
owning firms or performing certain jobs or
services
~ by raising the cost of entry
11-57
Restricting the Number of Firms
(cont.)
A limit on the number of firms causes a
shift of the supply curve to the left, which
raises the equilibrium price and reduces
the equilibrium quantity.
~ Consumers are harmed since they don’t buy
as much as they would at lower prices.
~ Firms that are in the market when the limits
are first imposed benefit from higher profits.
11-58
Restricting the Number of Firms:
Example
Regulation of taxicabs
Countries throughout the world limit the
number of taxicabs.
To operate a cab in these cities legally,
you must possess a city-issued permit,
which may be a piece of paper or a
medallion.
11-59
Effect of a Restriction on the Number of Cabs
11-60
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
11-61
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
11-62
Profit-Maximizing Labor Usage
(Figure 11.12)
11-63
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
~ SMC = a + 2bQ + 3cQ2
11-64
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
11-65
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
11-66
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
11-67
Profit & Loss at Beau Apparel
(Figure 11.13)
11-68
Profit & Loss at Beau Apparel
(Figure 11.13)
11-69
Summary
 Perfect competitors are price-takers, produce
homogenous output, and have no barriers to entry
 The demand curve for a perfectly competitive firm is
perfectly elastic (or horizontal) at the market
determined equilibrium price, and marginal revenue
equals price
 Managers make two decisions in the short run: (1)
produce or shut down, and (2) if produce, how much to
produce
~ When positive profit is possible, profit is maximized at the output
where P = SMC
~ When market price falls below minimum AVC the firm shuts
down and produces nothing, losing only TFC
11-70
Summary
 In long-run competitive equilibrium, all firms are in
profit-maximizing equilibrium (P = LMC)
~ No incentive for firms to enter or exit the industry because
economic profit is zero (P = LAC)
 Choosing either output or input usage leads to the
same optimal output decision and profit level
 Five steps to find the profit-maximizing rate of
production and the level of profit for a competitive firm:
1) Forecast the price of the product
2) Estimate average variable cost and marginal cost
3) Check the shutdown rule
4) If P ≥ min AVC find the output level where P = SMC
5) Compute profit or loss
11-71