Chapter 11 Managerial Decisions in Competitive Markets

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 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

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

Demand for a Competitive Price-Taking Firm (Figure 11.2) S Price (dollars) D Price (dollars) P0 P0 D = MR Q0 Quantity Quantity Panel A – Market Panel B – Demand curve facing a price-taker

Profit-Maximization in the Short Run In the short run, managers must make two decisions: Produce or shut down? If shut down, produce no output and hires no variable inputs If shut down, firm loses amount equal to TFC 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

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

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

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

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

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

Profit Maximization: P = $36 (Figure 11.3)

Profit Maximization: P = $36 (Figure 11.3)

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

Short-Run Loss Minimization: P = $10.50 (Figure 11.5) Total cost = $17 x 300 = $5,100 Profit = $3,150 - $5,100 = -$1,950 Total revenue = $10.50 x 300 = $3,150

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

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

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

Computing Short-Run Producer Surplus (Figure 11.6)

Short-Run Firm & Industry Supply (Figure 11.6)

Long-Run Profit-Maximizing Equilibrium (Figure 11.7) Profit = ($17 - $12) x 240 = $1,200

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

Long-Run Competitive Equilibrium (Figure 11.8)

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

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

Long-Run Industry Supply for a Constant Cost Industry (Figure 11.9)

Long-Run Industry Supply for an Increasing Cost Industry (Figure 11 Firm’s output

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

Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11)

Profit-Maximizing Input Usage Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

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 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

Profit-Maximizing Input Usage Average revenue product (ARP) Average revenue per worker Shut down in short run if ARP < MRP When ARP < MRP, TR < TVC

Profit-Maximizing Labor Usage (Figure 11.12)

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

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

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

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

Profit & Loss at Beau Apparel (Figure 11.13)

Profit & Loss at Beau Apparel (Figure 11.13)

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

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: Forecast the price of the product Estimate average variable cost and marginal cost Check the shutdown rule If P ≥ min AVC find the output level where P = SMC Compute profit or loss