Chapter 11: Managerial Decisions in Competitive Markets McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Chapter 11: Managerial Decisions in Competitive Markets

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

11-2

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

11-3

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

11-4

Demand for a Competitive Price-Taking Firm (Figure 11.2)

D

S

Quantity

Pri

ce (

dolla

rs)

Quantity

Pri

ce (

dolla

rs)

P0

Q0

Panel A – Market

Panel B – Demand curve facing a price-taker

0 0

P0D = MR

11-5

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

11-6

• 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

11-7

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

Average profit ( P ATC )Q

Q Q

Profit marginP ATC

11-8

Short-Run Output Decision

• Firm will produce output where P = SMC as long as:• Total revenue ≥ total avoidable cost or total

variable cost (TR TVC)

• Equivalently, the firm should produce if P AVC

11-9

Short-Run Output Decision

• The firm will shut down if:• Total revenue cannot cover total avoidable cost

(TR < TVC) or, equivalently, P AVC• Produce zero output• Lose only total fixed costs

• Shutdown price is minimum AVC

11-10

Fixed, Sunk,& Average Costs

• Fixed, sunk, & average costs are irrelevant in the production decision• Fixed costs have no effect on marginal cost or

minimum average variable cost—thus optimal level of output is unaffected

• Sunk costs are forever unrecoverable and cannot affect current or future decisions

• Only marginal costs, not average costs, matter for the optimal level of output

11-11

Profit Maximization: P = $36 (Figure 11.3)

11-12

Profit Maximization: P = $36 (Figure 11.3)

11-13

Panel A: Total revenue & total cost

Panel B: Profit curve when P = $36

Profit Maximization: P = $36 (Figure 11.4)

Break-even point

Break-even point

11-14

Short-Run Loss Minimization: P = $10.50 (Figure 11.5)

Total revenue = $10.50 x 300 = $3,150

Profit = $3,150 - $5,100 = -$1,950

11-15

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

11-16

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

11-17

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

11-18

Producer surplus TR TVC$9 110 $5.55 110 $990 $610 $380

Producer surplus = Area of trapezoid in Figure 11.6edbaOr, equivalently,

$380 multiplied by 100 firms ($380 100) $38,000

= Height Average base80 110

($9 $5)2

$380

Computing Short-Run Producer Surplus (Figure 11.6)

11-19

Short-Run Firm & Industry Supply (Figure 11.6)

11-20

Long-Run Profit-Maximizing Equilibrium (Figure 11.7)

Profit = ($17 - $12) x 240 = $1,200

11-21

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

11-22

Long-Run Competitive Equilibrium (Figure 11.8)

11-23

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

11-24

• 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

11-25

Long-Run Industry Supply for a Constant Cost Industry (Figure 11.9)

11-26

Long-Run Industry Supply for an Increasing Cost Industry (Figure 11.10)

Firm’s output

11-27

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

11-28

Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11)

11-29

Profit-Maximizing Input Usage• Profit-maximizing level of input usage

produces exactly that level of output that maximizes profit

11-30

• 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

TRMRP P MP

L

11-31

• 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

TRARP P AP

L

11-32

Profit-Maximizing Labor Usage (Figure 11.12)

11-33

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 + cQ2

• SMC = a + 2bQ + 3cQ2

11-34

• Step 3: Check shutdown rule

• If P AVCmin then produce

• If P < AVCmin then shut down

• To find AVCmin substitute Qmin into AVC

equation

Implementing the Profit-Maximizing Output Decision

2min min minAVC a bQ cQ

2min

bQ

c

11-35

• Step 4: If P AVCmin, find output where P = SMC• Set forecasted price equal to estimated

marginal cost & solve for Q*

Implementing the Profit-Maximizing Output Decision

P = a + 2bQ* + 3cQ*2

11-36

• Step 5: Compute profit or loss

• Profit = TR – TC

= P x Q* - AVC x Q* - TFC

= (P – AVC)Q* - TFC

• If P < AVCmin, firm shuts down & profit is -TFC

Implementing the Profit-Maximizing Output Decision

11-37

Profit & Loss at Beau Apparel (Figure 11.13)

11-38

Profit & Loss at Beau Apparel (Figure 11.13)