1. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Competitive Firm Chapter 7

2. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Profit Motive The basic incentive for producing goods and services is the expectation of profit. Profit is the difference between total revenue and total cost.

3. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Motivations Personal reasons also motivate producers. –Producers seek social status and crave recognition. –Non-owner managers of corporations may be more interested in their own jobs, salaries, and self-preservation than earning profits for stockholders.

4. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Is the Profit Motive Bad? The profit motive encourages businesses to produce the goods and services consumers’ desire, at prices they are willing to pay.

5. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic vs. Accounting Profits The typical consumer believes that 35¢ of every sales dollar goes to profits. In reality, average profit per sales dollar is closer to 5¢.

6. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profits Economic profit is the difference between total revenues and total economic costs. Economic cost is the value of all resources used to produce a good or service – opportunity cost.

7. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profits To determine a firm’s economic profit, all implicit factor costs must be subtracted from observed accounting profit.

8. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profits Normal profit is the opportunity cost of capital – zero economic profit. Economic profits represent something over and above normal profits.

9. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profits A productive activity reaps an economic profit only if it earns more than its opportunity cost.

10. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Economic Profits

11. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Entrepreneurship The inducement to take on the added responsibilities of owning and operating a business is the potential for profit.

12. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risk The potential for profit is not a guarantee of profit. Substantial risks are attached to starting and operating a business.

13. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure The opportunity for profit may be limited by the structure of the industry. Market structure is the number and relative size of firms in an industry.

14. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure Perfect competition is market in which no buyer or seller has market power. Monopoly is a firm that produces the entire market supply of a particular good or service.

15. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Structure OligopolyDuopolyMonopolyMonopolistic competition Perfect competition Imperfect competition

16. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Nature of Perfect Competition A perfectly competitive industry has several distinguishing characteristics: –Many firms – lots of firms are competing for consumer purchases. –Identical products – the products of the different firms are identical, or nearly so. –Low entry barriers – it’s relatively easy to get into the business.

17. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Takers A perfectly competitive firm has no market power and has no ability to alter the market price of the goods it produces. –Market Power - The ability to alter the market price of a good or service.

18. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Takers The output of a perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market.

19. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Demand Curves vs. Firm Demand Curves It is important to distinguish between the market demand curve and the demand curve confronting a particular firm. While the actions of a single competitive firm are negligible, the unified actions of many such firms are not.

20. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Demand Curves vs. Firm Demand Curves The market demand curve for a product is always downward-sloping. The demand curve confronting a perfectly competitive firm is horizontal.

21. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Quantity (shirts per day) Demand facing one shop PRICE (per shirt) Quantity (thousand shirts per day) Market Demand Curves vs. Firm Demand Curves Market demand Market supply Equilibrium price pepe The T-shirt market pepe Demand facing single firm

22. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Production Decision A competitive firm has only one decision to make: how much to produce. The production decision is the selection of the short-run rate of output (with existing plant and equipment).

23. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Revenues In searching for the most desirable rate of output, the distinction between total revenue and total profit must be kept in mind. –Total revenue - The price of the good multiplied by the quantity sold in a given time period. Total revenue = price X quantity

24. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Revenues The total revenue curve of a perfectly competitive firm is an upward-sloping straight line, with a slope equal to p e.

25. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Total revenue 0123456789101112 p e = $8 8 16 24 32 40 48 56 64 72 80 88 $96 Quantity Total Revenue

26. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Costs To maximize profits a firm must consider how increased production will affect costs as well as revenues.

27. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Costs Producers are saddled with certain costs in the short-run. –Short-run - The period in which the quantity (and quality) of some inputs cannot be changed.

28. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Costs Fixed costs are incurred even if no output is produced. –Fixed costs - Costs of production that do not change when the rate of output is altered, e.g., the cost of basic plant and equipment.

29. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Costs Once a firm starts producing output, it incurs variable costs as well. –Variable costs - Costs of production that change when the rate of output is altered, e.g. labor and material costs.

30. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Total Cost (dollars per time period) Output (units per time period) Total Cost z Total cost Fixed cost Total costs escalate due to the law of diminishing returns

31. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Costs The shape of the total cost curve reflects increasing marginal costs and the law of diminishing returns. –Marginal cost is the increase in total costs associated with a one-unit increase in production.

32. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output and Costs The primary objective of the producer is to find that one particular rate of output that maximizes profits.

33. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Output (units per period) Revenues Or Costs (dollars per period) Total Profit Total costTotal revenue Profits Losses r s fhg

34. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit-Maximizing Rule The best single rule for maximizing short- run profits is straightforward: Never produce a unit of output that costs more than it brings in.

35. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Revenue = Price The contribution to total revenue of an additional unit of output is called marginal revenue. For perfectly competitive firms, price equals marginal revenue.

36. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Revenue = Price Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in the quantity sold.

37. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Revenue = Price

38. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost A firm’s goal is not to maximize revenues, but to maximize profits. Marginal revenue is compared to marginal costs to determine the best level of output.

39. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost What an additional unit of output brings in is its marginal revenue (MR). What it costs to produce is its marginal cost (MC).

40. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Marginal Cost

41. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit-Maximizing Rate of Output According to the profit-maximization rule a firm should produce at that rate of output where marginal revenue equals marginal cost.

42. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit-Maximizing Rate of Output If marginal cost exceeds price, total profits decline if the additional output is produced. If marginal cost is less than price, total profits increase if the additional output is produced. Profits are maximized at the rate of output where price equals marginal cost.

43. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Profit-Maximization Rules for Competitive Firm Price > MC  increase output Price = MC  maintain output and maximize profit Price < MC  decrease output

44. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Quantity (bushels per day) 0 1234567 2 4 6 8 10 12 14 16 $18 Price or Cost (per bushel) Marginal cost Price (= MR) Profit-Maximizing Rate of Output Profit-maximizing rate of output MC B MR B p = MC Profits decreasing Profits increasing

45. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Adding Up Profits Profits can be computed in two ways. Total profit is the difference between total revenue and total cost. Total profit = total revenue – total cost

46. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Adding Up Profits Total profit is average profit times the number sold. Total profit = profit per unit X quantity Profit per unit = price – ATC Total profit = (p – ATC) X q

47. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Adding Up Profits The profit-maximizing producer never seeks to maximize per-unit profits. What counts is total profits, not the amount of profit per unit.

48. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Adding Up Profits The profit-maximizing producer has no desire to produce at that rate of output where ATC is at a minimum.

49. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Alternative Views of Total Profit 01234567 2 4 6 8 10 12 14 16 $18 Rate of Output Price or Cost (per unit) Price and average cost Profit per unit Marginal cost Total Profit Price Average total cost Cost per unit Revenue or Cost (dollars per day) Total revenue Maximum total profit Total cost 01234567 10 20 30 40 50 60 70 80 $90 Rate of Output Total revenue and total cost

50. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Shutdown Decision The short-run profit maximization rule does not guarantee any profits. Fixed costs must be paid even if all output ceases. A firm should shut down only if the losses from continuing production exceed fixed costs.

51. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Price vs. AVC Where price exceeds average variable cost but not average total cost, the profit maximizing rule minimizes losses.

52. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Shutdown Point When price does not cover average variable costs at any rate of output, production should cease. The shutdown point is that rate of output where price equals minimum AVC.

53. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Shutdown Point Loss Quantity 087654321 MC AVC ATC Price Y Shutdown Quantity 087654321 MC AVC ATC Price shutdown point Profit 0 18 16 14 12 10 8 6 4 2 8765 4321 Price or Cost Quantity MC AVC ATC X Price (=MR )

54. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Investment Decision The investment decision is the decision to build, buy, or lease plant and equipment. It also involves the decision to enter or exit an industry.

55. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Investment Decision The shut-down decision is a short-run response. Investment decisions are long-run decisions. –Long-run – A period of time long enough for all inputs to be varied (no fixed costs).

56. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Costs In making long-run decisions, the producer is confronted with many possible cost figures. A producer will want to build, buy or lease a plant that is most efficient for the anticipated rate of output.

57. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determinants of Supply The quantity of a good supplied is affected by all forces that alter marginal cost.

58. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Determinants The determinants of a firm’s supply include: –The price of factor inputs. –Technology (the available production function). –Expectations (for costs, sales, technology). –Taxes and subsidies.

59. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Supply Curve The marginal cost curve is the short-run supply curve for a competitive firm. –Supply curve – A curve describing the quantities of a good a producer is willing and able to sell (produce) at alternative prices in a given time period, ceteris paribus.

60. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Supply Curve 01234567 2 4 6 8 10 12 14 16 $18 Quantity Supplied (bushels per day) Price (per bushel) Marginal cost curve Short-run supply curve for competitive firm = Y X Shutdown point

61. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Supply Shifts If any determinant of supply changes, the supply curve shifts.

62. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Tax Effects Some tax changes alter short-run supply behavior. Others affect only long-run supply decisions.

63. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Property Taxes Property taxes are a fixed cost. They raise average costs and reduce profit. Because they don’t affect marginal costs, they leave the profit-maximizing output unchanged.

64. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Payroll Taxes Payroll taxes increase marginal costs. They reduce the profit maximizing rate of output. They increase average costs and lower total and per-unit profits.

65. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Profit Taxes Profit taxes are neither a fixed cost nor a variable cost. They don’t affect marginal cost or prices. They don’t affect production level decisions but may affect investment decisions.

66. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Impact of Taxes on Business Decisions pepe q1q1 MC 1 ATC a ATC 1 Property taxes affect fixed costs pepe q1q1 MC 1 ATC b ATC 1 MC b qbqb Payroll taxes alter marginal costs pepe MC 1 ATC 1 q1 Profits taxes don't change costs

67. McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Competitive Firm End of Chapter 7