1. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Class #10 Profit Maximization and Perfect Competition Fall 2010-11

2. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases The Economics of Production  Review… What is the most efficient (least cost) way to produce any given amount of output? –Budget Constraint – All the combinations of inputs which a firm can buy for a given budget. –Isoquant – All the combinations of input with which a firm can produce a given amount of output. –Technically Efficient (i.e., least cost) production – Choose the combination of inputs so that the contribution to output per dollar spent on an input is equated across inputs (the point where the slope of the Isoquant and the slope of the Budget Constraint are equal). –Expansion Path – What is the most efficient (lowest cost) way of producing any particular amount of production? –Average and Marginal Cost Curves – How costs vary as output changes Fall 2010-11

3. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Profit Maximization  Profit = Total Revenues (TR) – Total Costs (TC)  What do we mean by profit? –Economic Profit v. Accounting Profit  Is the assumption of profit maximization reasonable? What else might a firm maximize? –Total sales? –Size? –?? Fall 2010-11

4. Fall 2008-09 Fall 2009-10 The “Expansion Path” of Efficient Production Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases P W = $10/day Worker Days 10 Capital (Machinery) P M = $100/day M W Q TC AC At Pt. A 4 60 50 $1000 $20 At Pt. C 3 50 40 $800 $20 At Pt. D 7.5 75 60 $1500 $25 Q = 50 60 4A Q = 40 C 50 3 8 15 D 75 7.5 Expansion Path Q = 60 Fall 2010-11

5. Fall 2008-09 How Much Would a Manufacturer Pay for Steel? 20100 30600 401000 501300 601500 701600 Tons of Steel Output Q Marginal Product (MP =  Q/  Tons) Marginal Value to the Consumer Per Ton (PxMP) Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases $500 $400 $300 $200 $100 50 40 30 20 10 Suppose Consumer Price Per Unit of Output = $10 Mfgr’s Willingness to Pay for Steel Tons of Steel 10203040506070 $100 $200 $300 $400 $500 …It is the marginal contribution of value to consumers when steel is used in manufacturing. This willingness to pay is the mfgr’s DEMAND for steel… Fall 2010-11

6. Fall 2008-09 Fall 2009-10 The Relationship Between Average and Marginal Cost Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases $/Q Q Average Cost (AC) Marginal Cost (MC) Minimum of AC Fall 2010-11

7. Fall 2008-09 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Total and Marginal Cost 10$2000$200 20$2400$120 30$2900$96.67 40$3500$87.50 50$4200$84 60$5000$83.33 70$6000$85.71 Quantity (Q) Total Cost (TC) AC (= TC/Q) MC (=  TC/  Q) $50 $60 $70 $80 $100 $40 Fall 2010-11

8. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Total Cost Curve $ Q 1000 2000 3000 4000 5000 6000 10 20 30 40 50 60 70 80 Slope of Total Cost Curve = ∆TC/∆Q = Marginal Cost Fall 2010-11

9. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Demand Curve Facing the Firm  Total Revenues Price Quantity $150 70 10 $90 $140 20 Fall 2010-11

10. Fall 2008-09 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Total and Marginal Revenue 10$150$1500 20$140$2800 30$130$3900 40$120$4800 50$110$5500 60$100$6000 70$90$6300 Quantity (Q) Price (P) Total Revenue = P*Q MR (=  TR/  Q) $110 $90 $70 $50 $30 $130 Fall 2010-11

11. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Total Revenue Curve $ Q 1000 2000 3000 4000 5000 6000 10 20 30 40 50 60 70 80 Slope of Total Revenue Curve = ∆TR/∆Q = Marginal Revenue Fall 2010-11

12. Fall 2008-09 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Profit Maximization: Where is Profit (= TR – TC) greatest? 10$150$1500$2000-$500 20$140$2800$2400$400 30$130$3900$2900$1000 40$120$4800$3500$1300 50$110$5500$4200$1300 60$100$6000$5000$1000 70$90$6300$6000$300 Quantity (Q) Price (P) Total Rev (TR) Total Cost (TC) Profit (TR – TC) Fall 2010-11

13. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Profit Maximization $ Q 1000 2000 3000 4000 5000 6000 10 20 30 40 50 60 70 80 Total Cost Curve Total Revenue Curve Profit = Vertical Distance Between Total Revenue and Total Cost Curve Fall 2010-11

14. Fall 2008-09 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases What Output Maximizes Profits? …Where MR = MC 10$1500$2000 20$2800$2400 30$3900$2900 40$4800$3500 50$5500$4200 60$6000$5000 70$6300$6000 Quantity (Q) Total Rev (TR) Marginal Revenue Total Cost (TC) Marginal Cost $110 $90 $70 $50 $30 $130 $50 $60 $70 $80 $100 $40 Fall 2010-11

15. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Perfect Competition  Attributes of a Perfectly Competitive Market –Each firm is small relative to overall industry. –Each firm produces a homogenous product. –Firms can freely enter or exit the industry.  Implications: –Each firm is a price taker. They can sell as much or as little at the market price as they want without effecting the market price. –There are no “special” costs required to enter or exit the industry. In the long-run, firms will enter if there are profits to be made and will exit if losing money.  Examples –Agriculture Fall 2010-11

16. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases The Demand Curve Faced By A Price-Taking Firm Price $20 Market Price = $20 10 20 30 40 50 60 Quantity Demand What is the Marginal Revenue? Perfect Competition  Price = Marginal Revenue Fall 2010-11

17. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Short-Run Profit Maximization Price $20 10 20 30 40 50 60 Quantity Demand MR = P Marginal Cost Average Cost Profits Are Maximized where MR = MC qCqC Fall 2010-11

18. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Short-Run Profits for a Price-Taking Firm Price p C = $20 10 20 30 40 50 60 Quantity Demand MR = P Marginal Cost Average Cost q C =46 AC = $15 Profit = TR – TC = q c (p c ) – q c (AC) = q c (p c – AC) (p c – AC) = $5 Short-Run Profits = $5*46 = $230 Fall 2010-11

19. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Short-Run Losses in a Perfectly Competitive Industry Price p C = $12 10 20 30 40 50 60 Quantity Demand MR = P Marginal Cost Average Cost q C =34 AC = $13 Short-Run Losses = q c (p c - AC) = 34 * (-1) = -$34 AVC If Price is between AVC and AC, the firm covers its variable costs and is able to cover part of its fixed costs. Fall 2010-11

20. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Shutting Down Production in a Perfectly Competitive Industry Price 10 20 30 40 50 60 Quantity p C = $12 Demand MR = P Marginal Cost Average Cost q C =34 AVC If Price is below AVC, the firm doesn’t even cover its variable costs. The profit- seeking firm should shut down. Fall 2010-11

21. Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Short-Run Production (Supply) Curve How much would a firm produce at each price? 10 20 30 40 50 60 Quantity Marginal Cost Average Cost AVC Price Fall 2010-11