2. slide 1Competitive firms in the short-run PERFECT COMPETITION This section analyzes the behavior of firms that operate in competitive markets. We take up the short-run first, and focus on two issues: 1) How firms choose their outputs. 2) How prices are determined.

3. slide 2Competitive firms in the short-run In the short-run firms have some fixed costs. In addition, in the short-run firms cannot leave an industry, and new firms cannot enter.

4. slide 3Competitive firms in the short-run STANDARD PROBLEM Suppose a small accounting firm producing tax return preparation services in East Lansing, Michigan, has a short-run total cost curve like the one in our example. Suppose the firm is a perfect competitor and can sell its services at a price of $44 per unit. If the firm wants to maximize profits, how many tax preparations should it produce in each time period?

5. slide 4Competitive firms in the short-run The total cost curve looks like this.

6. slide 5Competitive firms in the short-run

7. slide 6Competitive firms in the short-run The firm’s total economic profit is total revenue minus total cost. Total revenue is price times quantity sold, where price means the revenue per unit that the firm takes in. Price is the fixed, known market price of the firm’s output.

8. slide 7Competitive firms in the short-run TR is price times quantity. Price here is $44/unit. PQ = 3(44) The total revenue curve shows total receipts at each level of output. The dependent variable is total revenue and the independent variable is output. QTR 00 144 288 3132 4176 5 6 7 8 9 10 11 Hidden slide

9. slide 8Competitive firms in the short-run TR is price times quantity. Price here is $44/unit. The total revenue curve shows total receipts at each level of output. The dependent variable is total revenue and the independent variable is output. QTR 00 144 288 3132 4176 5 6 7 8 9 10 11 264 308 352 396 440 484 PQ = 5(44) 220

10. slide 9Competitive firms in the short-run Graph the remaining points on the Total Revenue Curve. Hidden slide

11. slide 10Competitive firms in the short-run Note that because price is a constant here (P=44), the TR curve is a ray from the origin. TR is proportional to Q. TR=44*Q

12. slide 11Competitive firms in the short-run Here are the total revenue and cost curves. TC TR

13. slide 12Competitive firms in the short-run Profit = TR - TC = 132-76 Profit is total revenue minus total cost. QTCTRPROFIT 050.00-50.0 163.044-19.0 271.08817.0 376.013256.0 482.417693.6 597.0220 6130.0264 7174.0308 8233.0352 9314.0396 10460.0440-20.0 11656.0484-172.0 Hidden slide

14. slide 13Competitive firms in the short-run Profit is total revenue minus total cost. QTCTRPROFIT 050.00-50.0 163.044-19.0 271.08817.0 376.013256.0 482.417693.6 597.0220 6130.0264134.0 7174.0308 8233.0352 9314.0396 134.0 119.0 82.0 10460.0440-20.0 11656.0484-172.0 Profit = TR - TC = 220- 97 123.0

15. slide 14Competitive firms in the short-run Plot the missing points of the total profit curve. Hidden slide

16. slide 15Competitive firms in the short-run Profit is maximized between 6 and 7 units of output. PROFIT TR TC

17. slide 16Competitive firms in the short-run Where profit is maximized here is obvious from looking at the previous figure. The next thing to be shown is that the profit maximizing output is the output at which MARGINAL COST equals MARGINAL REVENUE.

18. slide 17Competitive firms in the short-run The profit maximization problem is going to be solved by looking at it from the point of view of average and marginal quantities and curves, instead of total quantities. The reason for doing this is that some problems are going to be much easier to solve if we look at the firm’s choices in terms of marginal and average revenue and cost.

19. slide 18Competitive firms in the short-run Recall what the marginal and average cost curves looked like in the case of our example. 0 20 40 60 80 100 120 02468101214 0 100 200 300 400 500 600 700 02468101214 $ TC Q $/Q MC AC Q

20. slide 19Competitive firms in the short-run Now for marginal revenue and average revenue. Average revenue: The firm’s total revenue divided by output. Revenue per unit of output. The same thing as PRICE. The average revenue curve shows average revenue as a function of output. The average revenue curve is the demand curve for output as seen by the firm. In the case of perfect competition, the average revenue curve is horizontal at the going market price. The firm is a price taker.

21. slide 20Competitive firms in the short-run THE AVERAGE REVENUE CURVE FOR A COMPETITIVE FIRM IS A HORIZONTAL LINE AT MARKET PRICE. P=AR

22. slide 21Competitive firms in the short-run Marginal revenue: The change in total revenue per unit change in output. The slope of the total revenue curve. MR =  TR /  Q. The marginal revenue curve shows marginal revenue at each level of output. Output is the independent variable, and MR is the dependent variable. For a competitive firm MR is constant.

23. slide 22Competitive firms in the short-run THE MARGINAL REVENUE CURVE FOR A COMPETITIVE FIRM IS A HORIZONTAL LINE AT MARKET PRICE. MR

24. slide 23Competitive firms in the short-run Important point In perfect competition, marginal revenue and average revenue are always equal and constant for a firm. The sense of this is that a competitive firm can always sell additional units of output at the going market price.

25. slide 24Competitive firms in the short-run The total revenue and the corresponding marginal and average revenue curves are a “matched set.” Notice that the rules governing the relationships between total, average, and marginal quantities hold here. 0 100 200 300 400 500 600 700 02468101214 0 20 40 60 80 100 120 02468101214 $ TR Q $/Q AR=MR Q

26. slide 25Competitive firms in the short-run Here’s the cost and revenue curves together on the same set of axes. MC AC MR

27. slide 26Competitive firms in the short-run Without the data markers the graphs look like this. The profit maximizing output here is 7 units. MC AC MR=P

28. slide 27Competitive firms in the short-run WHY MUST 7 BE THE PROFIT MAXIMIZING OUTPUT? MC AC MR=P

29. slide 28Competitive firms in the short-run REASONING: 1) Take any other output, say 4. 2) Now increase output by a small amount. 3) Profits increase, so they can’t be maximized at an output of 4. MC AC MR=P

30. slide 29Competitive firms in the short-run Be sure you understand why profits increase when output is increased from 4. The increase in output has two effects: it increases revenue and it increases costs. At output = 4, the increase in revenue exceeds the increase in costs, so profits grow. MC AC MR=P

31. slide 30Competitive firms in the short-run At an output of 9, profits can be increased by reducing output. Why? At output of 9, MC > MR. Therefore, a reduction in output reduces costs by more than it reduces revenues, so profits grow. MC AC MR=P

32. slide 31Competitive firms in the short-run At output of 7, MC = MR. That means that a small increase in output adds exactly as much to revenues as it does to costs. But adding the same amount to revenues as to costs leaves total profit unchanged. MC AC MR=P

33. slide 32Competitive firms in the short-run An important point: profits are not maximized at the bottom of the AC curve. 0 20 40 60 80 100 120 02468101214 $/Q MC MR=P AC Q Average cost is minimized here.

34. slide 33Competitive firms in the short-run Measuring total profits in the average/marginal approach to finding the profit maximizing output. MC AC MR=P First, find the area that corresponds to TR. (=PQ) Hidden slide

35. slide 34Competitive firms in the short-run Measuring total profits in the average/marginal approach to finding the profit maximizing output. MC AC MR=P The red bordered area is total revenue when output = 7.

36. slide 35Competitive firms in the short-run Measuring total profits in the average/marginal approach to finding the profit maximizing output. MC AC MR=P Then find the area that corresponds to TC. (= AC times Q) Hidden slide

37. slide 36Competitive firms in the short-run Measuring total profits in the average/marginal approach to finding the profit maximizing output. MC AC MR=P The blue bordered area is total cost when output = 7.

38. slide 37Competitive firms in the short-run Measuring total profits in the average/marginal approach to finding the profit maximizing output. MC AC MR=P The difference between the two is total profit. Show it here. Hidden slide

39. slide 38Competitive firms in the short-run Measuring total profits in the average/marginal approach to finding the profit maximizing output. MC AC MR=P Total Revenue area Total Cost area So Total Profit is this area.

40. slide 39Competitive firms in the short-run Can you find total profit at the output where average cost is minimized? Hidden slide

41. slide 40Competitive firms in the short-run 0 20 40 60 80 100 120 02468101214 $/Q MC MR=P AC Q

42. slide 41Competitive firms in the short-run Rule to remember: The output where profit is maximized is the output where MC = MR. (This rule works for all firms, not just firms in perfect competition.)

43. slide 42Competitive firms in the short-run The profit maximizing output here is 7 units. Review one more time!!! MC AC MR=P

44. slide 43Competitive firms in the short-run Producer Surplus The Producer Surplus for a firm is the difference between the amount of revenue the firm receives at a particular output level minus the minimum amount it would accept to produce that output. The next (hidden) slide shows how to find producer surplus for a competitive firm. Hidden slide

45. slide 44Competitive firms in the short-run PS for a competitive firm. Price MC $/Q Q Q* Total revenue Total (variable) cost Producer surplus