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Chapter 11-Managerial Decisions in Competitive Markets

This document discusses concepts related to perfect competition and profit maximization for firms in competitive markets. It defines key characteristics of perfect competition including firms being price-takers and producing homogeneous products. It then explains how firms in perfect competition determine optimal output levels in the short-run by producing where price equals marginal cost as long as price is above average variable cost. The document also discusses long-run competitive equilibrium and how free entry and exit of firms leads to zero economic profits.

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100% found this document useful (1 vote)
1K views32 pages

Chapter 11-Managerial Decisions in Competitive Markets

This document discusses concepts related to perfect competition and profit maximization for firms in competitive markets. It defines key characteristics of perfect competition including firms being price-takers and producing homogeneous products. It then explains how firms in perfect competition determine optimal output levels in the short-run by producing where price equals marginal cost as long as price is above average variable cost. The document also discusses long-run competitive equilibrium and how free entry and exit of firms leads to zero economic profits.

Uploaded by

naveen9622
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 11-

Managerial Decisions
in Competitive
Markets
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
 Free entry
Demand and Marginal
Revenue

 Demand is perfectly elastic


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
Profit-Maximization in the Short
Run
 In the short run, managers must make two
decisions:
 Produce or shut down?
 If shut down, produce no output and hires no variable
inputs
 If shut down, firm loses amount equal to TFC
 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
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 = π/Q = (P – ATC)*Q / Q


 = P – ATC = Profit Margin

 The manager should always produce where


 MR = MC
 For a perfectly competitive firm this also equals price
Profit Margin

 The greatest profit margin occurs at point N


 Total profit is not being maximized
Profit Maximization

 TR = 36*600
 TC = 19*600
 Total Profit =
17*600 = 10200
 At N TP
 = 20*400 = 8000
Short-Run Output Decision

 Firm’s manager will produce output where P =


MC as long as:
 TR ≥ TVC
 or, equivalently, P ≥ AVC
 If price is less than average variable cost (P <
AVC), manager will shut down
 Produce zero output
 Lose only total fixed costs
 Shutdown price is minimum AVC
Short Run Loss
Short Run Loss (P = $10.50)
 Do we operate in the short run?
 TR = 10.50 * 300 = 3150
 TC = 17 * 300 = 5100
 Total Profit = -1950
 Is this better than shutting down?
 Average fixed costs at 300 units are (17-9 = 8)
 Since fixed costs are constant they are 8*300 or
$2400
 Shutting down means we lose $2400
 Operate in the short run.
Irrelevance of Fixed Costs

 Fixed costs are irrelevant in the production


decision
 Level of fixed cost has no effect on marginal cost
or minimum average variable cost
 Thus no effect on optimal level of output
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 firms’ 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 Supply Curve
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
Producer Surplus –
Graphically
Producer Surplus –
Mathematically (P = 9)
 Producer Surplus = TR – TVC
 = 9 * 110 – 5.55 * 110 = $4.45 * 110 = $380
 $5.55 is AVC and $9 is Price
 We also can calculate the area on the graph
 Area of eabd
 The rectangle is = (9-5)*(80) = 320
 The triangle is = .5*(4)*(110-80) = 60
 PS = $380
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
LR Competitive Equilibrium

 Since economic profit = 5*240 = 1200


 With free entry firms will enter
Long Run Competitive
Equilibrium

 After firms enter, supply increases and prices


fall until P = MC = ATC = LAC
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
Long-Run Industry Supply
 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 for a
Constant Cost Industry

 Perfectly elastic supply


Long-Run Industry Supply for an
Increasing Cost Industry

 As supply increases, resource costs increase


causing LAC to increase
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

 Economic rents are seen when one firm is able to


produce at lower costs (entrepreneur talent)
Profit-Maximizing Input Usage

 Profit-maximizing level of input usage


produces exactly that level of output that
maximizes profit
Profit-Maximizing Input Usage
 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
∆TR
MRP = = P × MP
∆L
Profit-Maximizing Input Usage
 Average revenue product (ARP)
 Average revenue per worker
 Shut down in short run if ARP < MRP
 When ARP < MRP, TR < TVC

TR
ARP = = P × AP
L
Profit Maximizing Labor
Usage
 Max profit occurs
where MRP =
ARP

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