W08 - Managerial Decisions in Competitive Markets-FJO

Creating the great business leaders
Managerial Economics
By
Team Teaching FEB
Chapter 11 - Managerial Decisions in Competitive Markets
Christopher Thomas, S. Charles Maurice
2020
Fakultas Ekonomi dan Bisnis
School of Economic and Business Learning Objectives
Telkom University
After reading this chapter, you will be able to:
11.1 Discuss three characteristics of perfectly competitive markets.
11.2 Explain why the demand curve facing a perfectly competitive firm is
perfectly elastic and serves as the firm’s marginal revenue curve.
11.3 Find short-run profit-maximizing output, derive firm and industry supply
curves, and identify the amount of producer surplus earned.
11.4 Explain the characteristics of long-run competitive equilibrium for a firm,
derive long-run industry supply curves, and identify economic rent and
producer surplus.
11.5 Find the profit-maximizing level of usage of a variable input.
11.6 Employ empirically estimated or forecasted values of market price,
average variable cost, and marginal cost to calculate the firm’s profit-
maximizing output and profit.
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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

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■ 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

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Demand for a Competitive Price-Taking Firm (Figure 11.2)
Price (dollars)
Price (dollars)
P0 P0
D = MR
0 Q0 0
Quantity Quantity
Panel A – Market Panel B – Demand curve facing a

price-taker
Profit-Maximization in the
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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

Profit-Maximization in the Short Run

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■ 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

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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
 ( P  ATC )Q
Average profit  
Q Q
 P  ATC  Profit margin
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Short-Run Output Decision
■ Firm will produce output where P = SMC as long as:

● Total revenue ≥ total avoidable cost or total variable cost (TR 
TVC)
■ Equivalently, the firm should produce if P  AVC

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Short-Run Output Decision
■ The firm will shut down if:

● Total revenue cannot cover total avoidable cost (TR < TVC) or,
equivalently, P  AVC
● Produce zero output
● Lose only total fixed costs
● Shutdown price is minimum AVC

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Fixed, Sunk,& Average Costs
■ Fixed, sunk, & average costs are irrelevant in the production decision
● Fixed costs have no effect on marginal cost or minimum average
variable cost—thus optimal level of output is unaffected
● Sunk costs are forever unrecoverable and cannot affect current or
future decisions
● Only marginal costs, not average costs, matter for the optimal
level of output

Profit Maximization: P = $36 (Figure 11.3)

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Break-even point
Panel A: Total revenue & total

cost
Break-even point
Panel B: Profit curve when P = $36

Short-Run Loss Minimization: P = $10.50 (Figure 11.5)

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Profitcost
Total = $3,150
= $17 -x$5,100
300 ==
-$1,950
$5,100
Total revenue = $10.50 x 300 =

$3,150

Summary of Short-Run Output Decision

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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 P = SMC
●
■ ATC tells how much profit/loss if produce
π = (P – ATC)Q

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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

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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

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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

School of Economic and Business Long-Run Cost
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Figure 10.8 illustrates economies and diseconomies of scale.

Long-Run Profit-Maximizing Equilibrium (Figure 11.7)

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Profit = ($17 - $12) x 240 =

$1,200

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
● Long-run supply price rises & curve is upward sloping

Long-Run Industry Supply for a Constant Cost Industry

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(Figure 11.9)

Long-Run Industry Supply for an Increasing Cost Industry (Figure

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11.10)
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 long-run producer surplus is paid to
resource suppliers as economic rent

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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
TR
MRP   P  MP
L
• 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

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Profit-Maximizing Input Usage
■ Average revenue product (ARP)

● Average revenue per worker
TR
ARP   P  AP
L
• Shut down in short run if ARP < MRP

• When ARP < MRP, TR < TVC

School of Economic and Business Profit-Maximizing Input Usage
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■ Hire workers (L*) until MRP = w

● At L* TVC = L* w
● At L* TR = ARP * L*

Profit-Maximizing Labor Usage (Figure 11.12)

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Profit-Maximizing Labor Usage (Figure 11.12)

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Implementing the Profit-Maximizing Output Decision

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■ 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


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■ Step 3: Check shutdown rule

● If P  AVCmin then produce
● If P < AVCmin then shut down
● To find AVCmin substitute Qmin into AVC equation
b
Qmin 
2c
AVCmin  a  bQmin  cQ 2
min

School of Economic and Business Proof of AVC Min
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AVC  a  bQ  cQ 2
AVC
at min 0
Q
AVC
 b  2cQ  0
Q
b
 Qmin 
2c


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■ Step 4: If P  AVCmin, find output where P = SMC

● Set forecasted price equal to estimated marginal cost & solve for
Q*
P = SMC
P = a + 2bQ* + 3cQ*2


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■ Step 4: If P  AVCmin, find output where P = SMC

● Set forecasted price equal to estimated marginal cost & solve for
Q*
P  a  2bQ  3cQ* *2
b b  4ac
2
Q 
*
2c
11-41 Creating the great business leaders

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■ 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

Profit & Loss at Beau Apparel (Figure 11.13)

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Profit & Loss at Beau Apparel (Figure 11.13)

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School Economics and Business
TERIMA KASIH….
45 Creating the great business leaders

W08 - Managerial Decisions in Competitive Markets-FJO

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Creating the great business leaders

■ Firms are price-takers

Creating the great business leaders

Demand for a Competitive Price-Taker

■ Demand curve is horizontal at price determined by intersection of

Creating the great business leaders

Panel A – Market Panel B – Demand curve facing a

■ In the short run, managers must make two decisions:

Creating the great business leaders

Profit-Maximization in the Short Run

■ In the short run, the firm incurs costs that are:

Creating the great business leaders

■ Firm will produce output where P = SMC as long as:

Creating the great business leaders

■ The firm will shut down if:

Creating the great business leaders

Creating the great business leaders

Profit Maximization: P = $36 (Figure 11.3)

Creating the great business leaders

Profit Maximization: P = $36 (Figure 11.3)

Creating the great business leaders

Profit Maximization: P = $36 (Figure 11.4)

Panel A: Total revenue & total

Panel B: Profit curve when P = $36

Creating the great business leaders

Short-Run Loss Minimization: P = $10.50 (Figure 11.5)

Total revenue = $10.50 x 300 =

Creating the great business leaders

Summary of Short-Run Output Decision

■ AVC tells whether to produce

Creating the great business leaders

■ For an individual price-taking firm

Creating the great business leaders

■ Short-run producer surplus is the amount by which TR exceeds

Creating the great business leaders

■ All firms are in profit-maximizing equilibrium (P = LMC)

Creating the great business leaders

Figure 10.8 illustrates economies and diseconomies of scale.

Creating the great business leaders

Long-Run Profit-Maximizing Equilibrium (Figure 11.7)

Profit = ($17 - $12) x 240 =

Creating the great business leaders

Long-Run Competitive Equilibrium (Figure 11.8)

Creating the great business leaders

■ Long-run industry supply curve can be flat (perfectly elastic) or

Creating the great business leaders

■ Constant cost industry

Creating the great business leaders

Long-Run Industry Supply for a Constant Cost Industry

Creating the great business leaders

Long-Run Industry Supply for an Increasing Cost Industry (Figure

Creating the great business leaders

■ Payment to the owner of a scarce, superior resource in excess of

Creating the great business leaders

■ Marginal revenue product (MRP)

• Employ amount of input where MRP = input price

Creating the great business leaders

■ Average revenue product (ARP)

• Shut down in short run if ARP < MRP

Creating the great business leaders

■ Hire workers (L*) until MRP = w

Creating the great business leaders

Profit-Maximizing Labor Usage (Figure 11.12)

Creating the great business leaders