2. Ajax Company Scenarios for a Firm in Perfect Competition

3. Table of Contents 4 Cost Curves Cost Curves 4 Profit-Maximization Profit-Maximization 4 Find Total Revenue on a Graph Find Total Revenue on a Graph 4 Find Total Cost on a Graph Find Total Cost on a Graph 4 Economic Profit Economic Profit 4 Find Total Variable Cost on a Graph Find Total Variable Cost on a Graph 4 Find Total Fixed Cost Find Total Fixed Cost 4 Normal Profit Normal Profit 4 Economic Loss Economic Loss 4 Stay in Business Stay in Business 4 Shut Down Point Shut Down Point 4 Shut Down Shut Down

4. Ajax Company Cost Schedule

5. MC ATC AVC

6. Suppose the market equilibrium price is $180. Since the firm in perfect competition is a price taker, it can charge no more than the market equilibrium price.

7. P = MR = AR and the firm’s demand curve will be perfectly elastic at the market equilibrium price.

8. Ajax Company Data

9. The firm’s demand curve will be perfectly elastic at the market equilibrium price of $180 and MR and AR will both be $180.

10. D = MR = AR MC ATC AVC

11. Find the Profit Maximizing Quantity by Finding where MR=MC.

12. D = MR = AR MC ATC AVC MC=MR

13. Drop a Perpendicular Line Down to the Quantity Axis to Determine the Profit-Maximizing Quantity.

14. D = MR = AR MR=MC MC ATC AVC

15. To Find Total Revenue Compute P x Q

16. Ajax Company Data

17. To find Total Revenue for the Profit-Maximizing Quantity on the Graph, start at the quantity where MR=MC.

18. The Profit Maximizing Quantity is 7 units of output. The Price needed to sell 7 units of output can be found by going from 7 units of output on the output axis up to the Demand Curve.

19. D = MR = AR C D MC ATC AVC

20. The distance from the origin to 7 units of output is Q.

21. D = MR = AR A D MC ATC AVC

22. Since the distance from 7 up to the Demand Curve is the Price and the distance from the origin to 7 units of output is Q, Total Revenue is P x Q or the height of a rectangle times its base or the area indicated by ABCD.

23. D = MR = AR MC ATC AVC A B C D TR = ABCD

24. To Find Total Cost Compute TC = ATC x Q.

25. Ajax Company Data

26. Find the ATC for 7 Units of Output by going from 7 units of output on the quantity axis up to the ATC curve.

27. D = MR = AR MC ATC AVC

28. Draw the Total Cost Rectangle by drawing a base of 7 units (this is Q) times the height which is the ATC for 7 units. It is the area AEFD.

29. D = MR = AR A E F D MC ATC AVC TC = AEFC

30. If Total Cost and Total Revenue are drawn on the same graph

31. D = MR = AR A B C D EF MC ATC AVC TR = ABCE TC = AEFD

32. TR - TC = Economic Profit This is the rectangle EBCF.

33. D = MR = AR A B C D EF P R O F I T MC ATC AVC Economic Profit = EBCF

34. Now let’s see the whole process again.

35. D = MR = AR A B C D EF P R O F I T MC ATC AVCAVC

36. TVC = AVC x Q First find AVC for the Profit-Maximizing Quantity

37. D = MR = AR AVC MC ATC

38. Then draw the AVC x Q = TVC rectangle.

39. D = MR = AR A G H D TVC = AGHD MC ATC AVC

40. AFC for the Profit-Maximizing Quantity is the vertical distance between ATC and AVC at 7 units of output.

41. D = MR = AR ATC AVC F H

42. TFC is the rectangle which has a height of AFC and a base of Q.

43. D = MR = AR E G F H TFC = GEFH MC ATC AVC

44. Notice that the Total Variable Cost rectangle plus the Total Fixed Cost rectangle equal the Total Cost rectangle.

45. D = MR = AR A GH D E F Total Fixed Cost Total Variable Cost Total Cost = AEFD MC ATC AVC

46. Now suppose the market demand decreases and the market equilibrium price falls to $140.

47. D=AR=MR MC ATC AVC

48. Find the Profit Maximizing Quantity by finding where MR=MC

49. D=AR=MR MR=MC MC ATC AVC

50. Drop a perpendicular line down to the quantity axis to find the Profit-Maximizing quantity. The Profit-Maximizing quantity is now 6 units of output.

51. D=AR=MR MC ATC AVC

52. The Total Revenue rectangle is AR x Q or P x Q

53. D=AR=MR A BC D TR = ABCD MC ATC AVC

54. The Total Cost rectangle is ATC x Q

55. D=AR=MR A E F D ATC TC = ATC x Q =AEFD AVC MC FD = AT C for 6 units

56. If you compare the Total Revenue and Total Cost rectangles, you will notice they are the same. The firm is breaking even or earning a normal profit. Let’s see them again.

57. D=MR=AR A BC D MC ATC AVC

58. D=MR=AR A E F D MC ATC AVC

59. What happens if the market equilibrium price falls to $110? The demand curve, marginal revenue curve, and average revenue curve are now horizontal at $110.

60. D = MR = AR ATC AVC MC

61. Can the firm still break even? No. AR < ATC at every level of output.

62. D = MR = AR ATC AVC MC

63. Find the Profit-Maximizing Quantity by Finding where MR=MC and dropping down to the quantity axis. The Profit-Maximizing Quantity is now 5.

64. D = MR = AR MR=MC MC ATC AVC

65. The Total Revenue rectangle is AR x Q or P x Q

66. D = MR = AR A BC D MC ATC AVC

67. The Total Cost rectangle is ATC x Q

68. D = MR = AR A EF D ATC MC AVC

69. Draw Total Cost and Total Revenue on the Same Graph

70. D = MR = AR A BC D EF MC ATC AVC

71. In this case the Total Cost rectangle (AEFD) is larger than the Total Revenue rectangle (ABCD), so the firm is making an economic loss (BEFC)

72. D = MR = AR A BC D EF Economic loss MC ATC AVC

73. If the firm is making an economic loss, should it shut down? It depends. The firm wants to minimize its losses.

74. The firm needs to determine if it minimizes its losses by continuing to produce or by shutting down.

75. If the firm decides to shut down, its loss will be its Total Fixed Cost (because the Total Revenue is zero and the Total Cost IS its Total Fixed Cost when output is zero).

76. What is the TFC on the graph for 5 units of output? It is TC - TVC.

77. TC for 5 units of output was the rectangle AEFD:

78. D = MR = AR A EF D MC ATC AVC

79. TVC = AVC x Q for 5 units of output is the rectangle AGHD

80. D = MR = AR A G H D AVC MC ATC

81. TFC = TC - TVC or AEFD - AGHD

82. D = MR = AR EF GH Total Fixed Cost A D Total Fixed Cost = AEFC - AGHD = GEFH MC ATC AVC

83. We already found the total economic loss when the market price was $110 and the firm was loss minimizing. This was the rectangle BEFC.

84. D = MR = AR A BC D EF Economic loss Economic Profit = TR - TC = ABCD - AEFD = -BEFC = an Economic loss MC ATC AVC

85. The next step is to compare the loss when the firm shuts down (TFC) to the economic loss when it produces at the output level where MR = MC.

86. D = MR = AR EF GH A D B C Total Economic Loss = BEFC Total Fixed Cost = GEFH Which is the larger loss? Economic loss Total Fixed Cost MC ATC AVC

87. In this case, the firm has a larger economic loss if it shuts down and owes its Total Fixed Cost.

88. What would happen if the equilibrium market price fell down to $70? D, MR, and AR would now be horizontal at $70

89. MC ATC AVC D=MR=AR

90. At this lower price, AR<ATC by a larger amount than before. The firm is making a larger economic loss. Should it shut down?

91. MC ATC AVC D=MR=AR

92. Again we must compare what the firm loses if it stays in business to the total fixed cost it loses if it shuts down. Which will minimize the firm’s loss?

93. If it stays in business, it will produce where MR = MC at 3.5 units of output

94. MC ATC AVC D=MR=AR

95. Notice that the red dotted line which represents AR is the same vertical distance as the height to the AVC curve. This means that at $70, AR = AVC

96. MC ATC AVC D=MR=AR

97. TR = AR x Q for 3.5 units of output. Since AR = AVC at $70, TR also equals TVC. TR = AR x Q = AVC x Q = TVC

98. MC ATC AVC D=MR=AR A B C D TR = ABCD = TVC

99. TC = ATC x Q for 3.5 units

100. MC ATC AVC D=MR=AR A EF D

101. Put both Total Revenue and Total Cost on the same graph and find the Total Economic Loss BEFC

102. MC ATC AVC D=MR=AR Economic Loss A B EF C D

103. Total Economic Loss = TC - TR. Since TR = TVC when the price is $70, Economic Loss = TC - TVC = TFC This means that when the price is $70, the firm’s economic loss is its Total Fixed Cost.

104. If it shuts down it owes its TFC. So this firm owes its TFC if it operates where MR = MC at 3.5 units of output OR it owes its TFC if it shuts down. The loss is the same in either case.

105. MC ATC AVC D=MR=AR Economic Loss A B EF C D TFC

106. So what should this firm do when the price is $70, stay in business or shut down? It doesn’t matter. The firm will most likely stay in business hoping things will improve.

107. Now what happens if the market equilibrium price falls below $70, perhaps to $60?

108. MC ATC AVC D = MR = AR

109. Notice now that AR < AVC.

110. MC ATC AVC D = MR = AR

111. This means that TR < TVC. The firm is not earning enough revenue to even cover its Total Variable Cost.

112. MC ATC AVC D = MR = AR A BC D G H TR = ABCE TVC = AGHD

113. The firm owes all of its fixed costs plus part of its variable costs. It minimizes its loss by shutting down where it will only owe its Total Fixed Cost.

114. Its economic loss if it stays in business is TR - TC or BEFC

115. MC ATC AVC D = MR = AR B A C D E F Total Economic Loss = BEFC Economic loss

116. Its total economic loss if it shuts down is its Total Fixed Cost or GEFH

117. MC ATC AVC D = MR = AR E A F D GH TC = AEFD TVC = AGHD TFC = GEFH TFC

118. Let’s see both together.

119. MC ATC AVC D = MR = AR B A C D E F Total Economic Loss = BEFC TFC = GEFH G H Total Economic Loss TFC

120. Total Economic Loss is minimized if the firm shuts down.