Economic Analysis for Managers (ECO 501) Fall: 2012 Semester Khurrum S. Mughal

Market Structures Importance Number and size distribution of sellers Role in decision making Number and size distribution of sellers Number and size distribution of buyers Product differentiation Conditions of entry and exit

Competition The concept of competition is used in two ways in economics. Competition as a process is a rivalry among firms. Competition as the perfectly competitive market structure.

Perfect Competition A perfectly competitive market is one in which economic forces operate unimpeded.

The Necessary Conditions for Perfect Competition A perfectly competitive market must meet the following requirements: Both buyers and sellers are price takers. The number of firms is large. There are no barriers to entry. The firms’ products are identical. There is complete information. Firms are profit maximizers.

The Necessary Conditions for Perfect Competition Both buyers and sellers are price takers. A price taker is a firm or individual who takes the market price as given.

The Necessary Conditions for Perfect Competition The number of firms is large. Large means that what one firm does has no bearing on what other firms do. Any one firm's output is minuscule when compared with the total market.

The Necessary Conditions for Perfect Competition There are no barriers to entry. Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market. Barriers sometimes take the form of patents granted to produce a certain good. Technology may prevent some firms from entering the market. Social forces such as bankers only lending to certain people may create barriers.

The Necessary Conditions for Perfect Competition The firms' products are identical. This requirement means that each firm's output is indistinguishable from any competitor's product.

The Necessary Conditions for Perfect Competition There is complete information. Firms and consumers know all there is to know about the market – prices, products, and available technology. Any technological breakthrough would be instantly known to all in the market.

Market Demand Versus Individual Firm Demand Market supply Market demand 1,000 3,000 Price $10 8 6 4 2 Quantity Firm Individual firm demand 10 20 30

A firm maximizes profit when MC = MR. Profit-Maximizing Level of Output in the Short-run A firm maximizes profit when MC = MR. Marginal revenue (MR) – the change in total revenue associated with a change in quantity. Marginal cost (MC) – the change in total cost associated with a change in quantity.

Profit-Maximizing Level of Output A perfect competitor accepts the market price as given. As a result, marginal revenue equals price (MR = P). Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.

Profit-Maximizing Level of Output – Marginal Analysis P = D = MR Costs 1 2 3 4 5 6 7 8 9 10 Quantity 60 50 40 30 20 B MC $28.00 20.00 16.00 14.00 12.00 17.00 22.00 30.00 40.00 54.00 68.00 Price = MR Quantity Produced Marginal Cost $35.00 35.00 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Total Profit at the Profit-Maximizing Level of Output The P = MR = MC condition tells us how much output a competitive firm should produce to maximize profit. It does not tell us how much profit the firm makes.

Determining Profit and Loss From a Graph Quantity Price 65 60 55 50 45 40 35 30 25 20 15 10 5 1 2 3 4 6 7 8 9 12 D MC A P = MR B ATC AVC E Profit C Loss (a) Profit case (b) Zero profit case (c) Loss case Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

Determining Profit and Loss From a Graph Output where MC = MR. The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits. The firm makes a profit when the ATC curve is below the MR curve. The firm incurs a loss when the ATC curve is above the MR curve.

The Firm’s Short-Run Supply Curve A competitive firm is a price taker Takes market price as given and then decides how much output it will produce at that price Profit-maximizing output level is always found by traveling from the price, across to the firm’s MC curve, and then down to the horizontal axis, or As price of output changes, firm will slide along its MC curve in deciding how much to produce

The Firm’s Short-Run Supply Curve (a) (b) Bushels per Year Dollars Price per Bushel ATC MC Firm's Supply Curve $3.50 $3.50 2.50 2.50 2.00 2.00 AVC 1.00 1.00 0.50 0.50 1,000 4,000 7,000 2,000 4,000 7,000 2,000 5,000 5,000

Profit-Maximizing Level of Output – Using Mathematics New Pizza Place, Fredrico’s opens in Newyork. The average price per medium size pizza is $10. The estimated total cost function is: TC = 1000 + 2Q + 0.01Q2 Profit Maximizing Output Profit at that output

The Shutdown Point The firm will shut down if it cannot cover average variable costs. A firm should continue to produce as long as price is greater than average variable cost. If price falls below that point it makes sense to shut down temporarily and save the variable costs. The shutdown point is the point at which the firm will be better off it shuts down than it will if it stays in business.

The Shutdown Decision Bushels per Year Dollars ATC MC $3.50 d1=MR1 2.50 d2=MR2 2.00 d3=MR3 AVC 1.00 d4=MR4 0.50 d5=MR5 1,000 4,000 7,000 2,000 5,000

The Shutdown Decision Calculating the shutdown price TC = 1000 + 150Q – 20Q2 +Q3

The Shutdown Decision Short Run Long Run Cost of a shut down decision Is Price decline permanent?

Profit Maximizing Output in the Long Run Ease of entry and exit in perfect competition Resource allocation due to economic profits

Profit Maximizing Output in the Long Run Market Quantity Price S0 Firm Price Quantity MC AC D1 S1 $11 S2 $11 $9 840 $9 $ 7 730 $ 7 1,200 10 12 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Evaluating Perfect Competition

Evaluating Perfect Competition The value that the last consumer attaches to that output is just equal to the opportunity cost of producing that unit of output Voluntary exchange is maximized Efficient Allocation of Resources Production occurs at minimum cost