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Profit, Loss & Perfect Competition


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Market Types Maximizing Profit/Minimizing Loss The Marginal Revenue Curve Perfect Competition Short-Run vs Long-Run Questions for Next Time

Market Types

Each firm’s goal is to maximize profits – But Different competitive scenarios place unique decision making requirements on business managers Purpose of the next several chapters -- describe various competitive scenarios -- examine how business managers make decisions -- rational choice, balancing costs and benefits at the margin, and responding to incentives

Market Types  Perfect Competition Monopoly Monopolistic Competition Oligopoly    .

or MR = Change in Total Revenue Change in Output  As long as MR > MC. the addition to Total Profit is decreased and production should be decreased  Therefore Profit is Maximized (Losses Minimized) where MR = MC . the addition to Total Profit is increasing and production should be increased  As soon as MR < MC.Maximizing Profit/Minimizing Loss   Total Revenue = Price x Total Revenue Marginal Revenue = the increase in total revenue when output increases by one unit.

Inc.Graphing Demand & Marginal Revenue Marginal revenue is the increase in total revenue when output sold goes up by one unit Output 1 Price $5 Total Revenue $ 5 Marginal Revenue $5 2 3 4 5 6 5 5 5 5 5 10 15 20 25 30 5 5 5 5 5 Copyright 2002 by The McGraw-Hill Companies. 21-3 . All rights reserved.

MR 5 6 5 5 25 30 5 5 Copyright 2002 by The McGraw-Hill Companies. Inc. 21-4 . All rights reserved.Graphing Demand & Marginal Revenue Output Price Total Revenue Marginal Revenue 1 2 3 4 $5 5 5 5 $ 5 10 15 20 $5 5 5 5 6 5 4 3 2 1 0 0 1 2 3 4 Output 5 6 D.

Profit Maximization and Loss Minimization Output 1 1 1 2 1 3 1 4 1 5 1 6 7 Price $200 200 200 200 200 200 200 TR $200 400 600 800 1000 1200 1400 MR $200 200 200 200 200 200 200 TC $500 550 610 700 830 1000 1205 ATC $500 275 203 175 166 167 172 MC Total Profits $100 .150 60 10 90 100 130 170 170 200 205 195 Profit Maximization Point: MC = MR This occurs somewhere between 6 and 7 units. Inc. We are assuming output can be produced in tenths of a unit Copyright 2002 by The McGraw-Hill Companies. 21-6 .$300 50 . All rights reserved.

MR MC ATC 100 0 Most efficient Production Point: MC = ATC 0 1 2 3 4 Output 5 6 7 The most profitable output is where the MC curve crosses the D.7 units Copyright 2002 by The McGraw-Hill Companies. 21-7 . Inc. All rights reserved. This occurs at an output of 6.Profit Maximization and Loss Minimization Output MR MC 1 $200 $100 2 200 50 3 200 60 4 200 90 5 200 130 6 200 170 7 200 205 Profit Maximization Point: MC = MR 500 400 300 200 D. MR curve.

no restrictions on entry to or exit from the market -.many firms sell an identical product to many buyers -.established firms have no advantage over new firms -.sellers and buyers are well informed about prices Example: commodities.Market Types  Perfect Competition -. especially farming .

Perfect Competition      The firm has no control over its price – set by forces of market demand and supply The firm can sell all of its production at the going price The primary decision the firm must make is how much to produce It makes no sense to produce a single unit where what you receive (revenue/price) is less than the unit’s cost (ATC/MC) So. problem is to determine the profit maximizing level of output (TR-TC = Max Profit) .

or where TR-TC = Max P 2.Short Run Production Decisions How much the firm chooses to produce is becomes a question of production cost vs revenue The firm will logically choose to produce at a level that maximizes profit Two methods of computing that level of production 1. The point where Total Revenue – Total Cost = Max Profit. The point where Marginal Cost = Marginal Revenue. or where MC=MR    .

The Perfect Competitor’s Demand Curve Firm 9 8 7 6 5 4 3 2 1 D. Inc. 22-6 .MR 6 5 4 3 2 1 D Industry S 5 10 15 20 25 Output 30 1 2 3 4 5 6 Output (in millions) 7 The intersection of the industry supply and demand curve set the price that is taken by the individual firm. in this case $6 Copyright 2002 by The McGraw-Hill Companies. All rights reserved.

MR ATC In the short run the perfect competitor may make a profit or lose money 22-10 Copyright 2002 by The McGraw-Hill Companies. . Inc.The Perfect Competitor in the Short Run 20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 Output 14 16 18 20 D. All rights reserved.

22-13 .MR Is this firm making a profit or losing money? Answer: Making a profit because the D.MR curve is above the ATC curve Copyright 2002 by The McGraw-Hill Companies. Inc.The Perfect Competitor in the Short Run 20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 Output 14 16 18 20 ATC D. All rights reserved.

Exit & Temporary Shutdown Decisions When Total Costs exceed Total Revenue. what does the firm do?  In the long run. the firm must analyze its revenue & costs -. then the firm is incurring all its fixed costs plus some of the Variable Cost and the firm should consider a temporary shutdown  .If Revenue is less than Variable Cost. the firm may choose to exit the market if it feels the imbalance is permanent  In the short run. then some revenue is contributing toward covering part of fixed cost and the firm should continue to operate -.If Revenue exceeds Variable Cost.

Long Run. Means firm earns the “normal” profit only Economic Profit brings in other firms which increases competition – Industry Supply Curve shifts to the right = more product and lower prices Economic Loss induces higher cost firms to exit the industry – Industry Supply Curve shifts to the left = less product and higher prices for firms that are left . Price & Profit    In the long run the firm in perfect competition earns zero economic profit.Output.

but encourage new firms to enter the market A permanent decrease in demand triggers a similar response except in the opposite direction – incurring economic losses encourages firms to exit the industry  .Long Run – Permanent Change in Demand  A permanent increase in demand creates short term economic profits.

Inc.MR2 D1.MR1 ATC 18 16 14 12 10 8 6 4 2 0 0 1 2 3 Output (in millions) D S2 S1 20 Market This pushes the industry price up to $8.Going from Taking a Loss in the Short Run to Breaking Even in the Long Run Firm 20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 Output 14 16 18 20 D2. All rights reserved. 22-18 . At this price the firm breaks even. Copyright 2002 by The McGraw-Hill Companies.

22-20 . Inc.MR2 18 16 14 12 10 8 6 4 2 0 0 1 2 Output (in millions) 3 D 20 S1 S2 Market New firms are attracted into the industry. This increases supply moving the supply curve from S1 to S2 Copyright 2002 by The McGraw-Hill Companies.Going from Making a Profit in the Short Run to Breaking Even in the Long Run Firm 20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 Output 12 14 16 18 20 ATC D1.MR1 D2. All rights reserved.

All rights reserved. Inc. ATC will equal price at the break-even point (the minimum point on the ATC curve) 22-22 Copyright 2002 by The McGraw-Hill Companies.1 16 15 5 10 Output 15 20 In the long run the firm breaks even The ATC curve is tangent to the demand curve at the point where MC = MR.MR 18 17 The most profitable level of output is 11.The Perfect Competitor in the Long Run 24 MC 23 22 21 20 ATC Price = ATC 19 D. .

improvement in farm inputs (seed.External Economies & Diseconomies  External Economies – Factors beyond a firm’s control that will lower its costs as the market output increases -.Congestion (Airline Industry)  . fertilizer) -.technological change External Diseconomies – Factors beyond a firm’s control that will increase its costs as market output increases -.

one firm sells a good or service with no close substitutes -.a barrier blocks the entry of new firms Example: Utility companies/DeBeers in diamonds .Market Types  Monopoly -.

Although each firm has a monopoly on its brand. they still compete with one another Example: Nike/Reebok .Market Types  Monopolistic Competition -.Each producer is a sole producer of a particular version of the product (Branding) -.Large number of firms making similar but slightly different products -.

Market Types  Oligopoly -.Products might be very similar.Small number of firms compete and dominate the industry -. or they may have brand differentiation Example: Kodak/Fuji or Coke/Pepsi .