economia para la toma de decisiones cap 11

8/12/2019 Economia para la toma de decisiones Cap 11

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Economia Cap 11

Managerial decisions in competitive markets

Economic profit = Total revenue - Total economic cost = Total revenue - Explicit costs - Implicitcosts

The most important characteristic of perfectly competitive markets is that each firm in acompetitive market behaves as a price-taker: Competitive firms take the market price of theproduct, which is determined by the intersection of supply and demand, as given. This price-taking behavior is the hallmark of a competitive market. In all other market structuresmonopoly, monopolistic competition, and oligopolyfirms enjoy some degree of price-settingpower. Three characteristics define perfect competition:

1. Perfectly competitive firms are price-takers because each individual firm in the market is sosmall relative to the total market that it cannot affect the market price of the good or service it

produces by changing its output. Of course, if all producers act together, changes in quantity willdefinitely affect market price. But if perfect competition prevails, each producer is so small thatindividual changes will go unnoticed.

2. All firms produce a homogeneous or perfectly standardized commodity. The product of eachfirm in a perfectly competitive market is identical to the product of every other firm. Thiscondition ensures that buyers are indiffer- ent as to the firm from which they purchase. Productdifferences, whether real or imaginary, are precluded under perfect competition.

3. Entry into and exit from perfectly competitive markets are unrestricted. There are no barrierspreventing new firms from entering the market, and nothing prevents existing firms from leaving

a market.

11.2 DEMAND FACING A PRICE-TAKING FIRM

You wish to determine the maximum price you can charge for various levels of output of frozenconcentrate; that is, you wish to find the demand schedule facing your firm. After consulting TheWall Street Journal, you find that the market-determined price of orange juice concentrate is$1.20 per pound. You have 50,000 pounds of concentrate to sell, which makes your outputminuscule compared with the tens of mil- lions of pounds of orange juice concentrate sold in themarket as a whole. On top of that, you realize that buyers of orange juice concentrate dont carefrom whom they buy since all orange juice concentrate is virtually identical (homogeneous).

All at once it hits you like a ton of oranges: You can sell virtually all the orange juice concentrateyou wish at the going market price of $1.20 per pound. Even if you increased your output tenfoldto 500,000 pounds, you could still find buyers willing to pay you $1.20 per pound for the entire500,000 pounds because your output, by itself, is not going to affect (shift) market supply in anyperceptible way. Indeed, if you lowered the price to sell more oranges, you would be need- lesslysacrificing revenue. You also realize that you cannot charge a price higher than $1.20 per pound


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because buyers will simply buy from one of the thousands of other citrus producers that sellorange juice concentrate identical to your own.

By this reasoning, you realize that the demand curve facing your citrus grove can be drawn asshown in Figure 11.1. The demand for your firms product is horizontal at a price of $1.20 perpound of orange juice concentrate. The demand price for any level of orange juice concentrate is$1.20, no matter how many pounds you produce. This means that every extra pound soldcontributes $1.20 to total revenue, and hence the market price of $1.20 is also the marginalrevenue for every pound of orange juice concentrate sold. The demand curve facing the citrusproducer is also its marginal revenue curve.

The horizontal demand curve facing a price-taking firm is frequently called a per-fectly (orinfinitely) elastic demand. Recall from Chapter 6 that the point elasticity of demand is measuredby E = P/(P - A), where A is the price intercept of the demand curve. Measured at any givenprice, as demand becomes flatter, |P - A| becomes smaller and |E| becomes larger. In the limitwhen demand is horizontal, P - A = 0, and |E| = infinito`. Thus, for a horizontal demand, demandis said to be infi- nitely elastic or perfectly elastic.

The Output Decision: Earning Positive Economic Profit

Figure 11.3 shows a typical set of short-run cost curves: short-run marginal cost (SMC), averagetotal cost (ATC), and average variable cost (AVC).

Average profit= pi/Q= (Price-Average Total Cost) Q/Q

Profit margin= (P-ATC)

Lets now compute the profit when the manager mistakenly chooses to produce 400 units. Asyou can see in Panel A, at 400 units, total revenue is $14,400, which is price times quantity ($36x 400), and total cost is $6,400, which is average total cost times quantity ($16 x 400). Profit,then, is $8,000 (=$14,400 - $6,400) when the firm produces 400 units and maximizes profitmargin. So, whats wrong with making a profit of $8,000?

The answer is simple: This firm could make even more profit$10,200 to be precisebyproducing 600 units, as shown in Panel B. By expanding production from 400 to 600 units, totalprofit (p) rises as profit margin falls or, equivalently, as average profit falls. Plenty of highly paidCEOs find this outcome puzzling. Hardly a day passes that you will not see, somewhere in thebusiness news, an executive manager bragging about raising profit margins or promising to do soin the future. We will now clear up this confusion by employing the logic of marginal analysispresented in Chapter 3.

Return to point N in Panel A where the firm is producing and selling 400 units. Let the managerincrease production by 1 unit to 401 units. Because this firm is a price-taking firm for whichprice equals marginal revenue (P = $36 = MR), selling the 401st unit for $36 causes totalrevenue to rise by $36. Producing the 401st unit causes total cost to rise by the amount of short-run marginal cost, which is $16 (approximately). By choosing to produce and sell the 401st unit,


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the manager adds $36 to revenue and adds only $16 to cost, thereby adding $20 to the firmstotal profit. By this same reasoning, the manager would continue increasing production as longas MR (or, equivalently, P) is greater than SMC. From 401 units to 600 units at point A, eachunit adds to total profit the difference between P and SMC. Thus, output should be increased to600 units, as shown in Panel B, where P = MR 5 SMC = $36. At 600 units, total revenue is

$21,600 (=$36 3 600).

Total cost is $11,400 (=$19 x 600). Thus, the maximum possible profit is $10,200 (=$21,600 -$11,400). In Panel A, the gray-shaded area below MR and above SMC is equal to the value ofthe lost profit when only 400 units are produced instead of 600 units. We can summarize thisvery important discussion in a principle:

Managers cannot maximize both profit and profit margin at the same level of output. For thisreason, profit marginor, equivalently, average profitshould be ignored when making profit-maximizing decisions. When a firm can make positive profit in the short run, profit is maxi-mized at the output level where MR (= P) = SMC

Now suppose the manager makes the mistake of supplying too much output by producing andselling 630 units in Panel B. As you can see, marginal revenue (price) is now less than marginalcost: Price is $36 and marginal cost of the 630th unit is $40 (point H). The manager coulddecrease output by 1 unit and reduce total cost by $40 (the cost of the extra resources needed toproduce the 630th unit). The lost sale of the 630th unit would reduce revenue by only $36, so thefirms profit would increase by $4. By the same reasoning, the manager would continue todecrease production as long as MR (= P) is less than SMC (back to point A). The gray-shadedarea in Panel B is the lost profit from producing 630 units instead of 600 units. It follows from

this discussion that the manager maximizes profit by choosing the level of output where MR (=P) = SMC. This rule is, of course, the rule of unconstrained maximization set forth in Chapter 3(MB 5 MC) with profit serving as the net benefit (TB - TC) to be maximized.

Figure 11.4 shows the total revenue (TR), total cost (TC), and profit (pi) curves for the situationpresented in Figure 11.3. Notice in Panel A that TR is linear with slope equal to $36 (= P = MR)since each additional unit sold adds $36 to total revenue. Also note that in Panel B, at 401 units,the slope of the profit curve is $20, which follows from the preceding discussion about producingthe 401st unit. At 600 units, the maximum profit is $10,200, which occurs at the peak of theprofit curve (point A') where the slope of the profit curve is zero. The points U and V in Figure11.4 (100 units and 950 units) are sometimes called break-even points because total revenue

equals total cost and the firm earns zero profit.

Since the total cost of producing 600 units ($11,400) includes the opportunity cost of theresources provided by the firms owners (i.e., the implicit costs), the owners earn $10,200 morethan they could have earned if they had instead em- ployed their resources in their bestalternative. The $10,200 economic profit, then, is a return to the owners in excess of their bestalternative use of their resources.


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economia para la toma de decisiones cap 11

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