Managerial Decisions in Competitive Markets

BEC 30325Managerial Economics

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

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

Demand for a Competitive Price-taking Firm

D

S

Quantity

Pri

ce (

dolla

rs)

Quantity

Pri

ce (

dolla

rs)

P0

Q0

Market Demand curve facing a price-taker

0 0

P0D = MR

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

• 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

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

Profit Maximization: P = $36

Profit Maximization: P = $36

Panel A: Total revenue & total cost

Panel B: Profit curve when P = $36

Profit Maximization: P = $36

Break-even point

Break-even point

Short-run Loss Minimization: P = $10.50

Total cost = $17 x 300 = $5,100

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

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

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

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

Short-run Firm & Industry Supply

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

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

Long-run CostEconomies and diseconomies of scale.

Long-run Profit-Maximizing Equilibrium

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

Long-run Competitive Equilibrium

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

• 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

Long-run Industry Supply for a Constant Cost Industry

Long-run Industry Supply for an Increasing Cost Industry

Firm’s output

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

Economic Rent in Long-run Competitive Equilibrium

• Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

• 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

• 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

Profit-maximizing Labor Usage

• Hire workers (L*) until, MRP = w– At L* TVC = L* w– At L* TR = ARP * L*

Profit-maximizing Labor Usage

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

– TVC = Q(a + bQ + cQ2)– SMC = a + 2bQ + 3cQ2

• 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

Proof of AVC Min

c

bQ

cQbQ

AVC

Q

AVCat

cQbQaAVC

2

02

0min

min

2

• 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 = SMCP = a + 2bQ* + 3cQ*2

Implementing the Profit-maximizing Output Decision

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

marginal cost & solve for Q*

* *P a bQ cQ 22 3

c

acbbQ

2

42*

• 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

Profit & Loss at Beau Apparel

Profit & Loss at Beau Apparel