managerial decisions in competitive markets bec 30325 managerial economics
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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
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