Lecture Managerial economics (Ninth edition): Chapter 11 – Thomas, Maurice

Chapter 11 - Managerial decisions in competitive markets. In this chapter you will: Discuss three characteristics of perfectly competitive markets; apply the basic principles of marginal analysis to determine either (1) the profitmaximizing (or loss-minimizing) level of output, or (2) the profit-maximizing (or loss-minimizing) level of input usage; Explain why the demand curve facing an individual firm in a perfectly competitive industry is perfectly elastic, and why this demand curve is also the marginal revenue curve for a competitive firm;...

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Demand for a Competitive Price-Taker

• Demand curve is horizontal at price

determined by intersection of market demand & supply

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D S

Demand for a Competitive

P 0

D = MR

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Profit-Maximization in the Short Run

• In the short run, managers must make

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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

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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

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Total revenue =$36 x 600 Profit = $21,600 ­ $11,400  = $21,600         = 

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

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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

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• 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 

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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

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Short-Run Producer Surplus

• Short-run producer surplus is the

amount by which TR exceeds TVC

• The area above the short­run supply curve that is  below market price over the range of output 

supplied

• Exceeds economic profit by the amount of TFC

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Computing Short-Run Producer Surplus (Figure 11.6)

Or, equivalently,

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

= Height   Average base

80 110 ($9 $5)

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Short-Run Firm & Industry Supply (Figure 11.6)

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Long-Run Profit-Maximizing Equilibrium (Figure 11.7)

Profit = ($17 - $12) x 240

= $1,200

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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

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Long-Run Competitive Equilibrium (Figure 11.8)

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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

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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

• Long­run supply price rises & curve is upward sloping

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

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Long-Run Industry Supply for an

Firm’s  output

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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 long­run producer surplus 

is paid to resource suppliers as economic rent

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Economic Rent in Long-Run

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Profit-Maximizing Input Usage

• Profit-maximizing level of input

usage produces exactly that level

of output that maximizes profit

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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

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Profit-Maximizing Input Usage

• Average revenue product (ARP)

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Profit-Maximizing Labor Usage (Figure 11.12)

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Implementing the Maximizing Output Decision

Profit-• Step 3: Check shutdown rule

• If  P   AVCmin then produce

• If  P < AVCmin then shut down

• To find  AVCmin substitute  Qmin into  AVC   equation

min

b Q

c

2

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Profit & Loss at Beau Apparel (Figure 11.13)

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Profit & Loss at Beau Apparel (Figure 11.13)