Chapter 11: Managerial

Decisions in Competitive Markets

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 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

11-2
 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

11-3
 Demand for a Competitive
Price-Taking Firm (Figure 11.2)

P0 P0
D = MR

Price
Price

0 Q0 0

Quantity Quantity

Panel A – Panel B – Demand curve

Market facing a price-taker 11-4
 Profit-Maximization in the
Short Run
• In the short run, managers must make two
decisions:
1. Produce or shut down?
w If shut down, produce no output and hires no variable
inputs
w If shut down, firm loses amount equal to TFC
2. If produce, what is the optimal output level?
w If firm does produce, then how much?
w Produce amount that maximizes economic profit

Profit = π = TR - TC 11-5
 Repaso:
Maximización del beneficio: uso de factores de producción
C.P: Fijo
L.P: Variable

!" = $ %&, %( i =1
!" i = 1, 2

Q PMgx1

x1 x1 11-6
PMgx1 decrecientes implican diferentes costos

¿Cómo es la función de beneficios?

Q* Q

11-7
Decisión de oferta:
max & = max ! " − ) "
2 2

Donde: ! " = $"

C.P.O.
%&
= !' " − ) ' " = 0
%"
!' " = ) ' "
!+, = -+,
+. = +-
11-8
Decisión de oferta:
max %& − ((&)
$
S.A. &≥0

C.P.O. -.
= % − ( 0 &∗ = 0
-&
% = ( 0 &∗

C.S.O.
- 2. 00 & ∗ ≤ 0
= −(
-&2

11-9
Sabemos que: P

P* D ∆" = $∆%

Por tanto:
∆"
= "&' % = $ = ( ) %∗ = +&'(%)
∆%

11-10
¿De qué depende IMg y CMg?
IMg=p no hay mucho qué hacer
CMg: repaso de curvas de costos

11-11
Curvas de costos de la empresa

Supuesto crucial:
P y w dados

Costos: !" # = !%" # + !'"

Costos Medios (ATC):

!"(#) !%" # !'"
(!" # = = + = (%" # + ('"(#)
# # #
Costos Marginales (SMC):
∆!%" # !%" # + ∆# − !%"(#)
+," # = =
∆# ∆# 11-12
 AFC AVC ATC
C C C

Q Q Q

11-13
 ATC
C SMC
AVC

Q
11-14
Aspectos importantes:
ATC
C SMC
AVC

Q
11-15
Aspectos importantes:

C SMC

Costos variables

Q
11-16
Importancia de F. Condición de cierre.
Opción: no producir
Beneficios: -F
¿Producir o cerrar?
Conviene cerrar si
ATC
−"#$ > &' − "($ ' − "#$
C SMC
"($ ' AVC
>&
'
AVC ' > &

Q
11-17
Beneficios y excedente del productor ATC
Beneficios: C SMC
AVC

! = # $∗ − '($∗)
∗ ∗
'($) p*
! =* $ −$
$
! = *∗$∗ − $+,-($)

ATC
C SMC Q* Q

AVC
p*

Excedente del productor:

*$ − ,.- ($)
Q
Q* 11-18
 Profit-Maximization in the
Short Run
• 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 11-19
 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 ( P - ATC )Q
Average profit = =
Q Q
= P - ATC = Profit margin
11-20
Profit Maximization: P = $36
(Figure 11.3)

11-21
Profit Maximization: P = $36
(Figure 11.3)

11-22
 Profit Maximization: P = $36
(Figure 11.4)

Break-even point

Panel A: Total
revenue & total cost

Break-even point

Panel B: Profit curve

when P = $36

11-23
 Short-Run Output Decision
• Firm will produce output where P = SMC
as long as:
• Total revenue ≥ total avoidable cost or total
variable cost (TR ³ TVC)
• Equivalently, the firm should produce if
P ³ AVC

11-24
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)

Profit
Total = $3,150
cost = $17 x -300
$5,100
= -$1,950
= $5,100

Total revenue = $10.50 x 300

= $3,150

11-25
 Short-Run Output Decision
• Should the firm shut down?
TFC=$5100-$2700=$2400

Profit
Total = $3,150
cost = $17 x -300
$5,100
= -$1,950
= $5,100

Total revenue = $10.50 x 300

= $3,150

11-26
 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

11-27
 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
11-28
 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 ³ minimum AVC, produce output at
which P = SMC
• ATC tells how much profit/loss if
produce
π = (P – ATC)Q 11-29
 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
11-30
 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

11-31
Short-Run Firm & Industry Supply
(Figure 11.6)

11-32
 Computing Short-Run
Producer Surplus (Figure 11.6)
Producer surplus = TR - TVC
= $9 ´110 - $5.55 ´110
= $990 - $610
= $380
Or, equivalently,
Producer surplus = Area of trapezoid edba in Figure 11.6
= Height ´ Average base
æ 80 + 110 ö
= ($9 - $5) ´ ç ÷
è 2 ø
= $380
$380 multiplied by 100 firms = ($380 ´100) = $38, 000 11-33
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

11-34
 Long-Run Cost
Figure 10.8 illustrates economies and diseconomies of scale.

11-35
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)

Profit = ($17 - $12) x

240 = $1,200

11-36
Long-Run Competitive Equilibrium
(Figure 11.8)

11-37
 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

11-38
 Oferta de la industria en un mercado competitivo

Corto plazo Largo plazo

S1
S2 P S1
P S1+S2 S2

P*

Q Q
Beneficios nulos: deja de crecer

11-39
 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

11-40
 Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)

11-41
 Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)

Firm’s output

11-42
 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
11-43
 Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)

11-44
Profit-Maximizing Input Usage
• Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit

11-45
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
DTR
MRP = = P ´ MP
DL
• 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
11-46
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

11-47
Profit-Maximizing Labor Usage
(Figure 11.12)

11-48
Profit-Maximizing Labor Usage
(Figure 11.12)

11-49
 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

11-50
 Implementing the
Profit-Maximizing Output Decision
• Step 3: Check shutdown rule
• If P ³ AVCmin then produce
• If P < AVCmin then shut down
• To find AVCmin substitute Qmin into AVC
equation
b
Qmin =-
2c
AVC min = a + bQmin + cQ 2
min
11-51
Proof of AVC Min
AVC = a + bQ + cQ 2

¶AVC
at min =0
¶Q
¶AVC
= b + 2cQ = 0
¶Q
-b
\ Qmin =
2c

11-52
 Implementing the
Profit-Maximizing Output Decision
• Step 4: If P ³ AVCmin, find output where
P = SMC
• Set forecasted price equal to estimated
marginal cost & solve for Q*

P = SMC
P = a + 2bQ* + 3cQ*2

11-53
 Implementing the Profit-Maximizing
Output Decision
• Step 4: If P ³ AVCmin, find output where
P = SMC
• Set forecasted price equal to estimated
marginal cost & solve for Q*

P = a + 2bQ + 3cQ
* *2

- b ! b 2
- 4ac
Q =
*

2c
11-54
 Implementing the
Profit-Maximizing Output Decision
• 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
11-55
 Example: Beau Apparel
• Step 1: Forecast product price
• H:$20 M:$15 L:$10
• Step 2: Estimate AVC & SMC
• AVC = 20 – 0.003Q + 0.00000025Q2
• TVC = Q(20 – 0.003Q + 0.00000025Q2)
• SMC = 20 + 0.006Q + 0.00000075Q2

11-56
 Example Beau Apparel
• Step 3: Check shutdown rule
AVC = 20 – 0.003Q + 0.00000025Q2
Q=-(-0.003)/ (2*0.00000025)=6,000

AVC = 20 – 0.003(6000) + 0.00000025(6000)2

=$11
P=$20 > $11 = AVC
P=$15 > $11 = AVC
P=$10 < $11 = AVC
11-57
 Example: Beau Apparel
• Step 4: P=SMC

20=20-0.006Q+0.00000075Q2
Q=8000

15=20-0.006Q+0.00000075Q2
Q=7055

11-58
 Example: Beau Apparel
• Step 5: Compute profit or loss. Q=8000
• Profit = TR – TC
= 20 x 8000 - 12 x 8000 - 30000
= $34000
Because
AVC = 20 – 0.003(8000) + 0.00000025(8000)2
=$12

11-59
Profit & Loss at Beau Apparel
(Figure 11.13)

11-60
Profit & Loss at Beau Apparel
(Figure 11.13)

11-61