Managerial Economics ThomasMauriceeighth edition

The McGraw-Hill Series

Chapter 11

Managerial Decisions in Competitive Markets

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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

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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

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D

S

Quantity

Pri

ce (

dolla

rs)

Quantity

Pri

ce (

dolla

rs)

P0

Q0

Panel A – Market

Panel B – Demand curve facing a price-taker

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

0 0

P0D = MR

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Profit-Maximization in the Short Run• In the short run, managers must make

two decisions:1. Produce or shut down?

If shut down, produce no output and hires no variable inputs

If shut down, firm loses amount equal to TFC

2. If produce, what is the optimal output level?

If firm does produce, then how much? Produce amount that maximizes economic

profit TR TC Profit =

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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 ATC )Q

Q Q

Average profit

P ATC Profit margin

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Short-Run Output Decision

• Firm’s manager will produce output where P = MC as long as:• TR TVC• or, equivalently, P AVC

• If price is less than average variable cost (P AVC), manager will shut down• Produce zero output• Lose only total fixed costs• Shutdown price is minimum AVC

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Total revenue =$36 x 600 = $21,600

Profit = $21,600 - $11,400

= $10,200

Total cost = $19 x 600 = $11,400

Profit Maximization: P = $36 (Figure 11.3)

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Profit Maximization: P = $36 (Figure 11.4)

Panel A: Total revenue & total cost

Panel B: Profit curve when P = $36

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

Total cost = $17 x 300 = $5,100

Total revenue = $10.50 x 300 = $3,150

Profit = $3,150 - $5,100 = -$1,950

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Irrelevance of Fixed Costs

• Fixed costs are irrelevant in the production decision• Level of fixed cost has no effect on

marginal cost or minimum average variable cost

• Thus no effect on optimal level of output

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• AVC tells whether to produce• Shut down if price falls below

minimum AVC

• SMC tells how much to produce• If P minimum AVC, produce

output at which P = SMC

• ATC tells how much profit/loss if produce

Summary of Short-Run Output Decision

• ( P ATC )Q

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Short-Run Supply Curves

• For an individual price-taking firm• Portion of firms’ 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

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Derivation of Short-Run Supply Curves (Figure 11.6)

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Long-Run Profit-Maximizing Equilibrium (Figure 11.7)

Profit = ($17 - $12) x 240 = $1,200

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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

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Long-Run Competitive Equilibrium (Figure 11.8)

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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

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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

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

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

Firm’s output

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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 only normal profit• Economic profit is zero• Potential economic profit is paid to

the resource as rent

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

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Profit-Maximizing Input Usage

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

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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

• 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

TRMRP P MP

L

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Profit-Maximizing Input Usage

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

• Shut down in short run if ARP < MRP• When ARP < MRP, TR < TVC

TRARP P AP

L

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Profit-Maximizing Labor Usage (Figure 11.12)

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Implementing the Profit-Maximizing Output Decision

• Step 1: Forecast product price• Use statistical techniques from

Chapter 7

• Step 2: Estimate AVC & SMC

• SMC a bQ cQ22 3

• AVC a bQ cQ2

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Implementing the Profit-Maximizing Output Decision

• Step 3: Check shutdown rule• If P AVCmin, produce

• If P < AVCmin, shut down

• To find AVCmin, substitute Qmin into

AVC equation

min

bQ

c2

min min minAVC a bQ cQ2

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Implementing the Profit-Maximizing Output Decision

• Step 4: If P AVCmin, find output where P = SMC• Set forecasted price equal to

estimated marginal cost & solve for Q*

* *P a bQ cQ 22 3

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Implementing the Profit-Maximizing Output Decision

• Step 5: Compute profit or loss•Profit = TR - TC

• If P < AVCmin, firm shuts down &

profit is -TFC

* *P Q AVC Q TFC *( P AVC )Q TFC

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Profit & Loss at Beau Apparel (Figure 11.13)

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Profit & Loss at Beau Apparel (Figure 11.13)