Managerial Decisions in Competitive Markets BEC Managerial Economics

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 D S Quantity Price (dollars) Quantity Price (dollars) P0P0 Q0Q0 Market Demand curve facing a price-taker 0 0 P0P0 D = MR

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

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-Maximization in the Short-run

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

Profit Maximization: P = $36

Panel A: Total revenue & total cost Panel B: Profit curve when P = $36 Profit Maximization: P = $36 Break-even point

Short-run Loss Minimization: P = $10.50 Total cost = $17 x 300 = $5,100 Total revenue = $10.50 x 300 = $3,150 Profit = $3,150 - $5,100 = -$1,950

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 Firm & Industry Supply

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

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 Cost Economies and diseconomies of scale.

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

Long-run Competitive Equilibrium

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

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

Long-run Industry Supply for a Constant Cost Industry

Long-run Industry Supply for an Increasing Cost Industry 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

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

Profit-maximizing Labor Usage Hire workers (L * ) until, MRP = w – At L * TVC = L * w – At L * TR = ARP * L *

Profit-maximizing Labor Usage

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 + cQ 2 – TVC = Q(a + bQ + cQ 2 ) – SMC = a + 2bQ + 3cQ 2

Step 3: Check shutdown rule – If P  AVC min then produce – If P < AVC min then shut down – To find AVC min substitute Q min into AVC equation Implementing the Profit-maximizing Output Decision

Proof of AVC Min

Step 4: If P  AVC min, find output where P = SMC – Set forecasted price equal to estimated marginal cost & solve for Q * Implementing the Profit-maximizing Output Decision P = SMC P = a + 2bQ * + 3cQ *2

Implementing the Profit-maximizing Output Decision Step 4: If P  AVC min, find output where P = SMC – Set forecasted price equal to estimated marginal cost & solve for Q *

Step 5: Compute profit or loss – Profit = TR – TC = P x Q * - AVC x Q * - TFC = (P – AVC)Q * - TFC If P < AVC min, firm shuts down & profit is -TFC Implementing the Profit-maximizing Output Decision

Profit & Loss at Beau Apparel