 Many small firms  Standardized product  No need to advertise  “Price takers”  Free entry and exit  Perfectly elastic demand  Average revenue  Marginal revenue  Price 9-2

Demand for Perfectly Competitive Firms Why are they Price Takers? If a firm charges above the market price, NO ONE will buy. They will go to other firms There is no reason to price low because consumers will buy just as much at the market price. Since the price is the same at all quantities demanded, the demand curve for each firm is… Perfectly Elastic (A Horizontal straight line) 3 Copyright ACDC Leadership 2015

P Q Demand P Q 5000 D S Industry (all firms) $10 The Competitive Firm is a Price Taker Price is set by the Industry 4 Firm Copyright ACDC Leadership 2015

5 What is the additional revenue for selling an additional unit? 1 st unit earns $10 2 nd unit earns $10 Marginal revenue is constant at $10 Notice: Total revenue increases at a constant rate MR equal Average Revenue 5 MR=D=AR=P The Competitive Firm is a Price Taker Price is set by the Industry P Q Demand Firm $10 Copyright ACDC Leadership 2015

6 What is the additional revenue for selling an additional unit? 1 st unit earns $10 2 nd unit earns $10 Marginal revenue is constant at $10 Notice: Total revenue increases at a constant rate MR equal Average Revenue 6 MR=D=AR=P The Competitive Firm is a Price Taker Price is set by the Industry P Q Demand Firm $10 For Perfect Competition: Demand = MR (Marginal Revenue) Copyright ACDC Leadership 2015

Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 7 Copyright ACDC Leadership 2015

Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 8 Profit Maximizing Rule MR=MC Copyright ACDC Leadership 2015

P Q Demand P Q 10,000 D S Industry Firm (price taker) $7 9 ATC MC Lets put costs and revenue together to calculate profit. Copyright ACDC Leadership 2015

Total Revenue =$63 $ MC ATC How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? MR=D=AR=P Total Cost=$45 Profit = $18 10 Q P Copyright ACDC Leadership 2015

Suppose the market demand falls. What would happen if the price is lowered from $7 to $5? The MR=MC rule still applies but now the firm will make an economic loss. The profit maximizing rule is also the loss minimizing rule!!! 11 Copyright ACDC Leadership 2015

Total Revenue=$35 Cost and Revenue MC ATC How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? MR=D=AR=P Total Cost = $42 Loss =$7 $ Q

Assume the market demand falls even more. If the price is lowered from $5 to $4 the firm should stop producing. Shut Down Rule: A firm should continue to produce as long as the price is above the AVC When the price falls below AVC then the firm should minimize its losses by shutting down Why? If the price is below AVC the firm is losing more money by producing than they would have to pay to shut down. 13 Copyright ACDC Leadership 2015

TC=$35 TR=$ MC AVC ATC P<AVC. They should shut down Producing nothing is cheaper than staying open. MR=D=AR=P Fixed Costs=$10 $ Q Price Copyright ACDC Leadership 2015

Firms produce where MR=MC P1P1 0 Cost and Revenues (Dollars) Quantity Supplied MR 1 P2P2 MR 2 P3P3 MR 3 P4P4 MR 4 P5P5 MR 5 MC AVC ATC Q2Q2 Q3Q3 Q4Q4 Q5Q5 This Price is Below AVC And Will Not Be Produced a b c d e 9-15

P1P1 0 Cost and Revenues (Dollars) Quantity Supplied MR 1 P2P2 MR 2 P3P3 MR 3 P4P4 MR 4 P5P5 MR 5 MC AVC ATC Q2Q2 Q3Q3 Q4Q4 Q5Q5 a b c d e MC Above AVC Becomes the Short-Run Supply Curve S Examine the MC for the Competitive Firm Break-even (Normal Profit) Point Shut-Down Point (If P is Below) Firms produce where MR=MC 9-16

Three Characteristics of MR=MC Rule: 1.Rule applies to ALL markets structures (PC, Monopolies, etc.) 2.The rule applies only if price is above AVC 3.Rule can be restated P = MC for perfectly competitive firms (because MR = P) Profit Maximizing Rule MR = MC 17 Copyright ACDC Leadership 2015

18 Copyright ACDC Leadership 2015

$ MC ATC Should the firm produce? 2. What output should the firm produce? 3. What is the TR and TC at that output? 4. How much profit or loss? MR=D=AR= P Yes 10 TR=$140 Profit=$40 TC=$100 #1 19 Quantity Price Copyright ACDC Leadership 2015

MC MR=D=AR=P AVC ATC What output should the firm produce? What is TR at that output? What is TC? How much profit or loss? 6 $90 $120 Loss= $30 #2 20 Price Quantity Copyright ACDC Leadership 2015

$ MC MR=D=AR=P AVC ATC What output should the firm produce? 2. What is TR at MR=MC point? 3. What is TC at MR=MC point? 4. How much profit or loss? 9 Loss=Only Fixed Cost $5 Zero Shutdown (Price below AVC) $45 $55 #3 21 Price Quantity Copyright ACDC Leadership 2015

$ MC ATC Should the firm produce? 2. What output should the firm produce? 3. What is the TR and TC at that output? 4. How much profit or loss? MR=D=AR= P Yes 10 TR=$100 Profit=$40 TC=$60 #4 22 Quantity Price Copyright ACDC Leadership 2015

23 Output Variable Cost Fixed Cost Total Cost Marginal Cost 0$0$20- 1$12 2$22 3$27 4$40 5$60 6$100 Assume the firm can sell each unit at a price of $30 1.How many units should the firm produce to maximize profit? 2.What is the total revenue at that quantity? 3.How much is the profit? Copyright ACDC Leadership 2015 Notice that at 6 units the firm is still making profit. It’s just not maximizing profit

24 Output Variable Cost Fixed Cost Total Cost Marginal Cost 0$0$20- 1$12 2$22 3$27 4$40 5$60 6$100 Copyright ACDC Leadership 2015 Notice that at 6 units the firm is still making profit. It’s just not maximizing profit TRMRProfit --- $30 -$2 $60$30$18 $90$30$43 $120$30$60 $150$30$70 $180$30$60

25 Copyright ACDC Leadership 2015

$ Cost and Revenue AVC ATC 26 MR 1 Marginal Cost and Individual Supply MR 2 MR 3 MR 4 MR 5 MC Q Notice: As price increases, the quantity increases

Notice: The firm will not produce when MC is below AVC $ Cost and Revenue AVC ATC 27 Marginal Cost and Supply MC Q = Supply Copyright ACDC Leadership 2015 Short-run Supply Curve: MC above AVC

If variable costs increase (ex: per unit tax) $ Cost and Revenue AVC 28 Marginal Cost and Supply Q MC 1 =Supply 1 AVC MC 2 =Supply 2 When MC increases, SUPPLY decrease Copyright ACDC Leadership 2015

What if variable costs decrease (ex: subsidy)? $ Cost and Revenue AVC 29 Marginal Cost and Supply Q MC 1 =Supply 1 AVC MC 2 =Supply 2 When MC decreases, SUPPLY increases Copyright ACDC Leadership 2015

Marginal Cost and Supply MC ATC PFPF MR=D=AR= P 30 Quantity QFQF Price What happens to quantity if fixed costs increase? Quantity stays the same because MC/Supply doesn’t change ATC 1 Copyright ACDC Leadership 2015

31 Per Unit vs. Lump Sum A PER UNIT tax or subsidy affects the VARIABLE COSTS so MC, AVC, and ATC will shift. This WILL affect the quantity produced A LUMP SUM tax or subsidy only affects FIXED COSTS so only AFC and ATC will shift. MC stays the same. This WILL NOT affect the quantity produced Copyright ACDC Leadership 2015

2008 Audit Exam