Economic Discussion help

11.1 11.2 11.3 11.4 11.5 11.6 Summary

ECON 3305 Managerial Economics

Nazif Durmaz

University of Houston-Victoria

April, 2015

Chapter 11:Managerial Decisions in Competitive Markets

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Perfect Competition

I Firms are price-takers I Each produces only a very small portion of total market or

industry output

I All firms produce a homogeneous product

I Entry into & exit from the market is unrestricted

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Demand for a Competitive Price-Taker

I Demand curve is horizontal at price determined by intersection of market demand & supply

I Perfectly elastic

I Marginal revenue equals price I Demand curve is also marginal revenue curve (D = MR)

I Can sell all they want at the market price I Each additional unit of sales adds to total revenue an amount

equal to price

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Demand for a Competitive Price-Taking Firm Figure 11.2

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit-Maximization in the Short Run

I In the short run, managers must make two decisions: I Produce or shut down?

I If shut down, produce no output and hires no variable inputs I If shut down, firm loses amount equal to TFC

I If produce, what is the optimal output level? I If firm does produce, then how much? I Produce amount that maximizes economic profit

Profit = π = TR − TC

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit-Maximization in the Short Run

I In the short run, the firm incurs costs that are: I Unavoidable and must be paid even if output is zero I Variable costs that are avoidable if the firm chooses to shut

down

I In making the decision to produce or shut down, the firm considers only the (avoidable) variable costs & ignores fixed costs

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit Margin (or Average Profit)

I Level of output that maximizes total profit occurs at a higher level than the output that maximizes profit margin (& average profit)

I Managers should ignore profit margin (average profit) when making optimal decisions

AverageProfit = π

Q =

(P − ATC)Q Q

P − ATC = ProfitMargin

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Short-Run Output Decision

I Firm will produce output where P = SMC as long as: I Total revenue ≥ total avoidable cost or total variable cost

(TR ≥ TV C) I Equivalently, the firm should produce if P ≥ AV C I The firm will shut down if:

I Total revenue cannot cover total avoidable cost (TR < TV C) or, equivalently, P < AV C

I Produce zero output I Lose only total fixed costs I Shutdown price is minimum AV C

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Fixed, Sunk, & Average Costs

I Fixed, sunk, & average costs are irrelevant in the production decision

I Fixed costs have no effect on marginal cost or minimum average variable cost thus optimal level of output is unaffected

I Sunk costs are forever unrecoverable and cannot affect current or future decisions

I Only marginal costs, not average costs, matter for the optimal level of output

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit Maximization: P = $36 Figure 11.3

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit Maximization: P = $36 Figure 11.3

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ECON 3305 Managerial Economics

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Profit Maximization: P = $36 Figure 11.4

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ECON 3305 Managerial Economics

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

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ECON 3305 Managerial Economics

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Summary of Short-Run Output Decision

I AVC tells whether to produce I Shut down if price falls below minimum AVC

I SMC tells how much to produce I If P ≥ minimum AVC, produce output at which P = SMC

I ATC tells how much profit/loss if produce I π = (P − ATC)Q

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Short-Run Supply Curves

I For an individual price-taking firm I Portion of firm’s marginal cost curve above minimum AVC I For prices below minimum AVC, quantity supplied is zero

I For a competitive industry I Horizontal sum of supply curves of all individual firms; always

upward sloping I Supply prices give marginal costs of production for every firm

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Short-Run Producer Surplus

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

I The area above the short-run supply curve that is below market price over the range of output supplied

I Exceeds economic profit by the amount of TFC

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Computing Short-Run Producer Surplus (Figure 11.6)

ProducerSurplus = TR − TV C = ($9 × 110) − $5.55 × 110 = $990 − $610 = $380

I Or, Equivalently,

ProducerSurplus = Areaoftrapezoid(edba)Figure11.6

= Height × AverageBase

= ($9 − $5) × ( 80 + 110

2 )

= $380

I multiplied by 100 firms = ($380 × 100) = $38, 000 Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Short-Run Firm & Industry Supply Figure 11.6

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ECON 3305 Managerial Economics

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Long-Run Profit-Maximizing Equilibrium Figure 11.7

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ECON 3305 Managerial Economics

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Long-Run Competitive Equilibrium

I All firms are in profit-maximizing equilibrium (P = LMC) I Occurs because of entry/exit of firms in/out of industry

I Market adjusts so P = LMC = LAC

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Long-Run Competitive Equilibrium Figure 11.8

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Long-Run Industry Supply

I Long-run industry supply curve can be flat (perfectly elastic) or upward sloping

I Depends on whether constant cost industry or increasing cost industry

I Economic profit is zero for all points on the long-run industry supply curve for both types of industries

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Long-Run Industry Supply

I Constant cost industry I As industry output expands, input prices remain constant, &

minimum LAC is unchanged I P = minimum LAC, so curve is horizontal (perfectly elastic)

I Increasing cost industry I As industry output expands, input prices rise, & minimum LAC

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

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Long-Run Industry Supply for a Constant Cost Industry Figure 11.9

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ECON 3305 Managerial Economics

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Long-Run Industry Supply for an Increasing Cost Industry Figure 11.10

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ECON 3305 Managerial Economics

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Economic Rent

I Payment to the owner of a scarce, superior resource in excess of the resources opportunity cost

I In long-run competitive equilibrium firms that employ such resources earn zero economic profit

I Potential economic profit is paid to the resource as economic rent

I In increasing cost industries, all long-run producer surplus is paid to resource suppliers as economic rent

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Economic Rent in Long-Run Competitive Equilibrium Figure 11.11

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit-Maximizing Input Usage

I Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

I Marginal revenue product (MRP) I MRP of an additional unit of a variable input is the additional

revenue from hiring one more unit of the input

MRP = ∆TR

∆L = P × MP

I If choose to produce: I If the MRP of an additional unit of input is greater than the

price of input, that unit should be hired I Employ amount of input where MRP = input price

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit-Maximizing Input Usage

I Average revenue product (ARP) I Average revenue per worker

ARP = TR

L = P × AP

I Shut down in short run if ARP < MRP I When ARP < MRP , TR < TV C

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ECON 3305 Managerial Economics

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Profit-Maximizing Labor Usage Figure 11.12

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ECON 3305 Managerial Economics

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Implementing the Profit-Maximizing Output Decision

I Step 1: Forecast product price I Use statistical techniques from Chapter 7

I Step 2: Estimate AVC & SMC I AV C = a + bQ + cQ2

I SMC = a + 2bQ + 3cQ2

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Implementing the Profit-Maximizing Output Decision

I Step 3: Check shutdown rule I If P ≥ AV Cmin then produce I If P < AV Cmin then shut down I To find AV Cmin substitute Qmin into AVC equation

Qmin = − b

2c AV Cmin = a + bQmin + cQ

2 min

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Implementing the Profit-Maximizing Output Decision

I Step 4: If P ≥ AV Cmin, find output where P = SMC I Set forecasted price equal to estimated marginal cost & solve

for Q∗

I P = a + 2bQ∗ + cQ∗2

I Step 5: Compute profit or loss

Profit = TR − TC = P × Q∗ − AV C × Q∗ − TFC = (P − AV C) × Q∗ − TFC

I If P < AV Cmin, firm shuts down & profit is −TFC

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Profit & Loss at Beau Apparel Figure 11.13

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ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Summary

Concluding Remarks

I Perfect competitors are price-takers, produce homogenous output, and have no barriers to entry

I The demand curve for a perfectly competitive firm is perfectly elastic (or horizontal) at the market determined equilibrium price, and marginal revenue equals price

I Managers make two decisions in the short run: (1) produce or shut down, and (2) if produce, how much to produce

I When positive profit is possible, profit is maximized at the output where P = SMC

I When market price falls below minimum AVC the firm shuts down and produces nothing, losing only TFC

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics

11.1 11.2 11.3 11.4 11.5 11.6 Summary

Summary

Concluding Remarks

I In long-run competitive equilibrium, all firms are in profit-maximizing equilibrium (P = LMC)

I No incentive for firms to enter or exit the industry because economic profit is zero (P = LAC)

I Choosing either output or input usage leads to the same optimal output decision and profit level

I Five steps to find the profit-maximizing rate of production and the level of profit for a competitive firm:

I Forecast the price of the product I Estimate average variable cost and marginal cost I Check the shutdown rule I If P ≥ minAV C find the output level where P = SMC I Compute profit or loss

Nazif Durmaz University of Houston-Victoria

ECON 3305 Managerial Economics