Managerial Economics

Managerial Decisions in Perfectly

Competitive Markets

11-1
 Managerial Economics
The Four Types of Market Structure

Number of
Firms?
Many
firms

Type of
Products?

One Few Differentiated Identical

firm firms products products

Monopolistic Perfec
Monopoly Oligopoly Competition t
Competition

• Tap water • Tennis balls • Novels • Wheat

• Cable TV • Crude oil • Movies • Milk

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 Managerial Economics

Perfect Competition- Features

• Large number of buyers and sellers
• All firms produce a homogeneous product
• Entry into & exit from the market is
unrestricted
• Perfect knowledge of the markets
 Managerial Economics

Perfect Competition- Features

• Perfectly elastic demand curve
• Perfect mobility of factors of production
• No government intervention
• Firms are price-takers
– Each produces only a very small portion of total
market or industry output

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 Managerial Economics

Demand for a Competitive Price-Taking

Firm

Price (dollars)
Price (dollars)

P0 P0
D = MR

0 Q0 0

Quantity Quantity

Panel A – Market Panel B – Demand curve

facing a price-taker
 Managerial Economics

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
Managerial Economics

Objective of the Firm

How much What Price

to Produce? to charge?

Manager’s Dilemma

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 Managerial Economics

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 =
11-8
 Managerial
Table Economics
1 Total, Average, and Marginal Revenue for a
Competitive Firm

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 Managerial Economics
PROFIT MAXIMIZATION AND THE COMPETITIVE
FIRM’S SUPPLY CURVE
• The goal of a competitive firm is to maximize
profit.
• This means that the firm will want to produce
the quantity that maximizes the difference
between total revenue and total cost.
 Managerial Economics
Table 2 Profit Maximization: A Numerical Example

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 Managerial Economics
Figure 1 Profit Maximization for a Competitive Firm

Cost
s an The firm maximizes
d
Revenu profit by producing
e the quantity at which
marginal cost M
marginal
equals C

M revenue.
2
C
AT
P=M 1 =M 2
C
P = AR = M
R R AV R
C

M 1
C

0 Q1 QMA Q2 Quantity
X

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 Managerial Economics
PROFIT MAXIMIZATION AND THE COMPETITIVE
FIRM’S SUPPLY CURVE
• Profit maximization occurs at the quantity where
marginal revenue equals marginal cost.
• When MR = MC Profit is maximized.
 Managerial Economics

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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 Managerial Economics

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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 Managerial Economics

The Firm’s Short-Run Decision to Shut Down

• A shutdown refers to a short-run decision not to

produce anything during a specific period of time
because of current market conditions.
• Exit refers to a long-run decision to leave the market.
• The firm considers its sunk costs when deciding to
exit, but ignores them when deciding whether to
shut down.
– Sunk costs are costs that have already been
committed and cannot be recovered.
 Managerial Economics

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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 Managerial Economics

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
•

11-18
 Managerial Economics
THE SUPPLY CURVE IN A
COMPETITIVE MARKET
• Market supply equals the sum of the
quantities supplied by the individual firms in
the market.
 Managerial Economics
Figure 5 Profit as the Area between Price and Average Total Cost

(a) A Firm with

Profits
Pric
e
MC ATC
Profi
t
P

ATC P = AR = MR

0 Q Quantit
(profit-maximizing y
quantity) Copyright © 2004 South-Western
 Managerial Economics
Figure 5 Profit as the Area between Price and Average Total Cost

(b) A Firm with

Losses
Pric
e

MC ATC

ATC

P P = AR = MR

Los
s

0 Q Quantit
(loss-minimizing y
quantity) Copyright © 2004 South-Western
Managerial Economics

Long-Run Competitive Equilibrium

11-22
 Managerial Economics
The Short Run: Market Supply with a Fixed
Number of Firms
• For any given price, each firm supplies a
quantity of output so that its marginal cost
equals price.
• The market supply curve reflects the
individual firms’ marginal cost curves.
 Managerial Economics

The Long Run: Market Supply with Entry and Exit

• Firms will enter or exit the market until profit

is driven to zero.
• In the long run, price equals the minimum of
average total cost.
• The long-run market supply curve is horizontal
at this price.
 Managerial Economics
Why Do Competitive Firms Stay in Business If
They Make Zero Profit?
• Profit equals total revenue minus total cost.
• Total cost includes all the opportunity costs of
the firm.
• In the zero-profit equilibrium, the firm’s
revenue compensates the owners for the time
and money they expend to keep the business
going.
 Managerial Economics
A Shift in Demand in the Short Run and Long
Run
• An increase in demand raises price and
quantity in the short run.
• Firms earn profits because price now exceeds
average total cost.
 Managerial Economics
Figure 8 An Increase in Demand in the Short Run and Long Run

(a) Initial Condition

Fir Market
m
Pric Pric
e e

MC ATC Short-run supply, S1

A
P1 P1 Long-run
supply

Demand, D1

0 Quantity (firm) 0 Q1 Quantity (market)

 Managerial Economics
Figure 8 An Increase in Demand in the Short Run and Long Run

(b) Short-Run Response

Fir Market
Pric m Pric
e e

Profit MC ATC S1
B
P2 P2
A
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Quantity (market)

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 Managerial Economics
Figure 8 An Increase in Demand in the Short Run and Long Run

(c) Long-Run Response

Fir Market
m
Pric Pric
e e

MC S1
ATC B S2
P2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market)

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