Chapter11

ManagerialDecisionsinCompetitiveMarketsLearningObjectivesDiscuss3characteristicsofperfectlycompetitivemarketsExplainwhythedemandcurvefacingaperfectlycompetitivefirmisperfectlyelasticandservesasthefirm’smarginalrevenuecurveFindshort‐runprofit‐maximizingoutput,derivefirmandindustrysupplycurves,andidentifyproducersurplusExplaincharacteristicsoflong‐runcompetitiveequilibriumforafirm,derivelong‐runindustrysupply,andidentifyeconomicrentandproducersurplusFindtheprofit‐maximizinglevelofavariableinputEmployempiricallyestimatedvaluesofmarketprice,averagevariablecost,andmarginalcosttocalculateprofit‐maximizingoutputandprofitPerfectCompetitionFirmsareprice-takersEachproducesonlyaverysmallportionoftotalmarketorindustryoutputAllfirmsproduceahomogeneousproductEntryinto&exitfromthemarketisunrestrictedDemandforaCompetitivePrice-TakerDemandcurveishorizontalatpricedeterminedbyintersectionofmarketdemand&supplyPerfectlyelasticMarginalrevenueequalspriceDemandcurveisalsomarginalrevenuecurve(D=MR)CansellalltheywantatthemarketpriceEachadditionalunitofsalesaddstototalrevenueanamountequaltopriceDemandforaCompetitivePrice-TakingFirm(Figure11.2)DSQuantityPrice(dollars)QuantityPrice(dollars)P0Q0PanelA–MarketPanelB–Demandcurvefacingaprice-taker00P0D=MRProfit-MaximizationintheShortRunIntheshortrun,managersmustmaketwodecisions:Produceorshutdown?Ifshutdown,producenooutputandhiresnovariableinputsIfshutdown,firmlosesamountequaltoTFCIfproduce,whatistheoptimaloutputlevel?Iffirmdoesproduce,thenhowmuch?ProduceamountthatmaximizeseconomicprofitProfit=π=TR-TCIntheshortrun,thefirmincurscoststhatare:UnavoidableandmustbepaidevenifoutputiszeroVariablecoststhatareavoidableifthefirmchoosestoshutdownInmakingthedecisiontoproduceorshutdown,thefirmconsidersonlythe(avoidable)variablecosts&ignoresfixedcostsProfit-MaximizationintheShortRunProfitMargin(orAverageProfit)Levelofoutputthatmaximizestotalprofitoccursatahigherlevelthantheoutputthatmaximizesprofitmargin(&averageprofit)Managersshouldignoreprofitmargin(averageprofit)whenmakingoptimaldecisionsShort-RunOutputDecisionFirmwillproduceoutputwhereP=SMC

aslongas:Totalrevenue≥totalavoidablecostortotalvariablecost(TRTVC)Equivalently,thefirmshouldproduceifPAVCShort-RunOutputDecisionThefirmwillshutdownif:Totalrevenuecannotcovertotalavoidablecost(TR<TVC)or,equivalently,PAVCProducezerooutputLoseonlytotalfixedcostsShutdownpriceisminimumAVCFixed,Sunk,&AverageCostsFixed,sunk,&averagecostsareirrelevantintheproductiondecisionFixedcostshavenoeffectonmarginalcostorminimumaveragevariablecost—thusoptimallevelofoutputisunaffectedSunkcostsareforeverunrecoverableandcannotaffectcurrentorfuturedecisionsOnlymarginalcosts,notaveragecosts,matterfortheoptimallevelofoutputProfitMaximization:P=$36(Figure11.3)ProfitMaximization:P=$36(Figure11.3)PanelA:Totalrevenue&totalcostPanelB:ProfitcurvewhenP=$36ProfitMaximization:P=$36(Figure11.4)Break-evenpointBreak-evenpointShort-RunLossMinimization:P=$10.50(Figure11.5)Totalrevenue=$10.50x300 =$3,150Profit=$3,150-$5,100 =-$1,950SummaryofShort-RunOutputDecisionAVC

tellswhethertoproduceShutdownifpricefallsbelowminimumAVCSMCtellshowmuchtoproduceIfPminimumAVC,produceoutputatwhichP=SMCATCtellshowmuchprofit/lossifproduce

π=(P–ATC)QShort-RunSupplyCurvesForanindividualprice-takingfirmPortionoffirm’smarginalcostcurveaboveminimumAVCForpricesbelowminimumAVC,quantitysuppliediszeroForacompetitiveindustryHorizontalsumofsupplycurvesofallindividualfirms;alwaysupwardslopingSupplypricesgivemarginalcostsofproductionforeveryfirmShort-RunProducerSurplusShort-runproducersurplusistheamountbywhichTRexceedsTVCTheareaabovetheshort-runsupplycurvethatisbelowmarketpriceovertherangeofoutputsuppliedExceedseconomicprofitbytheamountofTFCComputingShort-RunProducerSurplus(Figure11.6)Short-RunFirm&IndustrySupply(Figure11.6)Long-RunProfit-MaximizingEquilibrium(Figure11.7)Profit=($17-$12)x240 =$1,200Long-RunCompetitiveEquilibriumAllfirmsareinprofit-maximizingequilibrium(P=LMC)Occursbecauseofentry/exitoffirmsin/outofindustryMarketadjustssoP=LMC=LACLong-RunCompetitiveEquilibrium(Figure11.8)Long-RunIndustrySupplyLong-runindustrysupplycurvecanbeflat(perfectlyelastic)orupwardslopingDependsonwhetherconstantcostindustryorincreasingcostindustryEconomicprofitiszeroforallpointsonthelong-runindustrysupplycurveforbothtypesofindustriesConstantcostindustryAsindustryoutputexpands,inputpricesremainconstant,&minimumLACisunchangedP=minimumLAC,socurveishorizontal(perfectlyelastic)IncreasingcostindustryAsindustryoutputexpands,inputpricesrise,&minimumLACrisesLong-runsupplypricerises&curveisupwardslopingLong-RunIndustrySupplyLong-RunIndustrySupplyforaConstantCostIndustry(Figure11.9)Long-RunIndustrySupplyforanIncreasingCostIndustry(Figure11.10)Firm’soutputEconomicRentPaymenttotheownerofascarce,superiorresourceinexcessoftheresource’sopportunitycostInlong-runcompetitiveequilibriumfirmsthatemploysuchresourcesearnzeroeconomicprofitPotentialeconomicprofitispaidtotheresourceaseconomicrentInincreasingcostindustries,alllong-runproducersurplusispaidtoresourcesuppliersaseconomicrentEconomicRentinLong-RunCompetitiveEquilibrium(Figure11.11)Profit-MaximizingInputUsageProfit-maximizinglevelofinputusageproducesexactlythatlevelofoutputthatmaximizesprofitMarginalrevenueproduct(MRP)MRPofanadditionalunitofavariableinputistheadditionalrevenuefromhiringonemoreunitoftheinputIfchoosetoproduce:IftheMRP

ofanadditionalunitofinputisgreaterthanthepriceofinput,thatunitshouldbehiredEmployamountofinputwhereMRP

=inputpriceProfit-MaximizingInputUsageAveragerevenueproduct(ARP)AveragerevenueperworkerShutdowninshortrunifARP<MRPWhen

ARP<MRP,TR<TVCProfit-MaximizingInputUsageProfit-MaximizingLaborUsage(Figure11.12)ImplementingtheProfit-MaximizingOutputDecisionStep1:ForecastproductpriceUsestatisticaltechniquesfromChapter7Step2:EstimateAVC

&SMCAVC=a+bQ+cQ2SMC=a+2bQ+3cQ2Step3:CheckshutdownruleIfP

AVCminthenproduceIfP<AVCminthenshutdownTofindAVCminsubstituteQminintoAVCequationImplementingtheProfit-MaximizingOutputDecisionStep4:IfPAVCmin,findoutputwhereP=SMCSetforecastedpriceequaltoestimatedmarginalcost&solveforQ*ImplementingtheProfit-MaximizingOutputDecisionP=a+2bQ*+3cQ*2Step5:ComputeprofitorlossProfit=TR–TC=PxQ*-AVCxQ*-TFC=(P–AVC)Q*-TFCIf

P<AVCmin,firmshutsdown&profitis-TFCImplementingtheProfit-MaximizingOutputDecisionProfit&LossatBeauApparel(Figure11.13)Profit&LossatBeauApparel(Figure11.13)SummaryPerfectcompetitorsareprice-takers,producehomogenousoutput,andhavenobarrierstoentryThedemandcurveforaperfectlycompetitivefirmisperfectlyelastic(orhorizontal)atthemarketdeterminedequilibriumprice,andmarginalrevenueequalspri