Post on 29-Dec-2015
MODERN PRINCIPLES OF ECONOMICSThird Edition
Costs and Profit Maximization Under Competition
Chapter 11
Outline
What price to set? What quantity to produce? Profits and the average cost curve Entry, exit, and shutdown decisions Entry, exit, and industry supply curves
2
Introduction
Every producer must answer three questions:
• What price to set?• What quantity to produce?• When to enter and exit the industry?
This chapter will look at the answers for a competitive industry.
3
What Price to Set?
In a competitive market, producers are “price takers”: • The firm accepts the price that is determined
by the market. • A firm can sell all its output at market price. • A firm can’t sell any output at a higher price. • The firm’s demand is perfectly elastic at
market price.
4
What Price to Set?
PricePrice
Quantity(barrels)
Quantity(barrels)
Marketdemand
Marketsupply
$50
Demandfor one firm’s oil
82,000,000
5
World Market For Oil Individual Firm’s Demand
2 5 10
What Price to Set?
An industry is competitive when firms don’t have much influence over the price of their product.
This is a reasonable assumption when: • The product being sold is similar across
sellers.• There are many buyers and sellers, each
small relative to the total market.• There are many potential sellers.
Demand is most elastic in the long run.
6
Definition
Long run:
the time after all exit or entry has occurred.
7
Short run:
the time period before exit or entry can occur.
8
Self-Check
In a perfectly competitive market, a firm will set its price:
a. Equal to its cost of production.
b. Equal to its costs plus a normal markup.
c. Equal to market price.
Answer: c – Firms in a competitive industry are price takers, and must accept market price.
What Quantity to Produce?
It depends on the objective. We assume the objective is to maximize profit.
Maximizing profit means maximizing the difference between total revenue and total costs. • Total revenue is Price x Quantity. • Total costs include opportunity costs. • Must distinguish between many different kinds
of cost (average, marginal, fixed, and so on). 9
Profit = π = Total Revenue – Total Cost
Definition
Total revenue:
price times quantity sold.
10
Total cost:
cost of producing a given quantity of output.
TR = P x Q
Opportunity Costs
Total costs include:• Explicit money costs and • Implicit opportunity costs, or the costs of
foregone alternatives. Output decisions should be based on all costs,
including opportunity costs.
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Definition
Explicit cost:
a cost that requires a money outlay.
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Implicit cost:
a cost that does not require an outlay of money.
Definition
Accounting profit:
total revenue minus explicit costs.
13
Economic profit:
total revenue minus total costs including implicit costs.
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Self-Check
Economic profit is total revenue minus:
a. Explicit costs.
b. Implicit costs.
c. Both explicit and implicit costs.
Answer: c – Economic profit equals total revenue minus both explicit and implicit costs.
Definition
Fixed costs:
costs that do not vary with output.
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Variable costs:
costs that do vary with output.
Maximizing Profit
We can break total costs into two components: fixed costs and variable costs.
Profit is the difference between total revenue and total cost.
To find the maximum profit, one method is to find the quantity that maximizes TR − TC.
16
TC = FC + VC
Maximizing Profit
We can use another method of finding the maximum profit.
We can compare the increase in revenue from selling an additional unit (MR) to the increase in cost from selling an additional unit (MC).
A firm should keep producing as long Marginal Revenue (MR) > Marginal Cost (MC)
The last unit produced should be the one where MR = MC.
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Definition
Marginal revenue (MR):
the change in total revenue from selling an additional unit.
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MR = TR / Q
Maximizing Profit
For a firm in a competitive industry, the demand curve is perfectly elastic.
The firm doesn’t need to drop the price to sell more units.
Each additional unit can be sold at market price. For a firm in a competitive industry, MR = Price.
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Definition
Marginal cost (MC):
the change in total cost from producing an additional unit.
20
21
Self-Check
A competitive firm will maximize its profit at the quantity:
a. Where MR = Price.
b. Where MR = MC.
c. Where MC = 0.
Answer: b – a competitive firm will maximize its profit by producing at the quantity where marginal revenue (MR) = marginal cost (MC).
Maximizing Profit
=
Maximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
100
$150
50
0
MR = P
At a Quantity of 8, MR = MC
Profits are maximized
WorldMarketprice
23
Marginalcost
More profit More profit
Maximizing Profit
As the price changes, so does the profit-maximizing quantity.
If price increases, the firm will expand production.
Will continue to expand until it is once again maximizing profit where P = MC.
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Maximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
$100
$150
$50
0
MR = P
Marginalcost
As Price increases, the firm expands production along its MC curve
WorldMarketprice MR = P
25
26
Self-Check
If price increases, a firm will:
a. Expand production.
b. Decrease production.
c. Price does not affect how much a firm produces.
Answer: a – if price increases, a firm will expand production.
Definition
Average Cost of Production:
the cost per unit, or the total cost of producing Q units divided by Q.
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AC = TC / Q
Profits and the Average Cost Curve
A firm can maximize profits and still have low profits or even losses.
It can be useful to show profits in a diagram. To do this, we need average cost (cost per unit). We can then calculate profitability.
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( )Profit = x Q –
TC Q
TR Q
Profits and the Average Cost Curve
we can also write
We then substitute:
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Profit = TR – TC
TR = P x Q
Profits and the Average Cost Curve
we can also write
We can also substitute:
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Profit = TR – TC
AC = TC / Q
( )Profit = x Q –
P x Q Q
TC Q
Profits and the Average Cost Curve
we can also write
We end up with:
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Profit = TR – TC
Profit = (P – AC) x Q
( )Profit = x Q –
P x Q Q
AC
Profits and the Average Cost Curve
This formula tells us that Profit is equal to the average profit per unit (P − AC) times the number of units sold (Q).
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Profit = (P – AC) x Q
Profits and the Average Cost Curve
33With an average cost curve, we can show profits on a graph.
Profit = (50-25.75) x 8 = $194
Maximizing Profit
Price
Quantity0 102 3 4 5 6 7 8 91
$100
50
0
MR = P
Marginalcost
AverageCost (AC)
• Profits are maximized at MR = MC, where Q = 8
• At Q = 8, AC = $25.75• Profit = (P – AC) x Q
25.75
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• MR = MC doesn’t mean the firm makes a profit
• Minimum AC is $17• At any price below $17,
P < AC → Losses
Maximizing Profit
Price
Quantity0 102 3 4 5 6 7 8 91
$100
50
0
MR = P
AverageCost (AC)
35
17Price = 10
Loss
Marginalcost
Cost = 20
Maximizing Profit
Price
Quantity0 102 3 4 5 6 7 8 91
$100
50
0
AverageCost (AC)
36
17
Marginalcost
P = MC > AC is a profit
P = MC < AC is a loss
The MC curve crosses the AC curve at its minimum point
37
Self-Check
If a firm produces at the output where MR = MC, it will always make a profit.
a. True.
b. False.
Answer: b – False; if average cost is greater than price, the firm will have a loss.
Entry, Exit, and Shutdown
38
Firms seek profits so in the long run: • Firms will enter the industry when P > AC. • Firms will exit the industry when P < AC.
When P = AC, profits are zero and there is no incentive to enter or exit.
Zero profits means that the price is just enough to pay labor and capital their opportunity costs.
Zero profits really means normal profits.
Entry, Exit, and Shutdown
39
Typically, exit cannot occur immediately.
In the short run, a firm must pay its fixed costs whether it is operating or not.
Fixed costs therefore do not influence decisions in the short run.
The firm should shut down immediately only if TR < VC.
TC = VC + FC
Entry, Exit, and Shutdown
40
If Price is below the minimum of AVC, then the firm should shut down immediately.
If Price is above AVC but below AC, then the firm should continue producing but exit as soon as possible.
If Price is at or above AC, the firm should continue producing where P = MC, or enter if it is not already in the industry.
Entry, Exit, and Shutdown
41
The firm’s entry, exit, and shutdown decisions.
Entry, Exit, and Industry Supply
42
The slope of the supply curve can be explained by how costs change as industry output changes.
Supply curves can slope upward, be flat, or in rare circumstances even slope downward.
Definition
Increasing Cost Industry:An industry in which industry costs increase with greater output; shown with an upward sloped supply curve.
43
Increasing Cost Industry
Costs rise as industry output increases. Greater quantities can only be obtained by using
more expensive methods. Any industry that buys a large fraction of the
output of and increasing cost industry will also be an increasing cost industry.
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Increasing Cost Industry
Firm 1 – oil is near the surface; lower costs Firm2 – oil is located deeper; higher costs
Firm 1 P PP
q2 Qq1
MC1 MC2AC2
AC1
$50
$17
$29
4 5 76 8 4 11 15
SIndustry
P < $17 → Q = 0P = $17 → Q = q1 + q2 = 4P = $29 → Q = q1 + q2 = 11P = $50 → Q = q1 + q2 = 15 45
Firm 2 Industry
Definition
Constant Cost Industry:An industry in which industry costs do not change with greater output; shown with a flat supply curve.
46
Constant Cost Industry
A constant cost industry has two characteristics:
1. It meets the conditions for a competitive industry. • The product is similar across sellers.• There are many buyers and sellers, each small relative
to the total market.• There are many potential sellers.
2. It demands only a small share of its major inputs. • The industry can expand or contract without changing
the prices of its inputs.
47
Constant Cost Industry
Market FirmPP
$6.99
SSA
DA
AC
MC
QA qA
A
↑ Market demand → ↑ market price → ↑ profits↑ profits → Existing firms ↑ q → ↑ Q↑ profits → Firms enter → Short-run supply shifts right → ↓ P, ↑QProfits return to normal
$7.99
DB
A
QB qB
SSBBB
C C
QC
LRS
48
Constant Cost Industry
Implications of a constant cost industry:
Price is driven down to AC, so profits are driven down to normal levels.
Price doesn’t change much because AC doesn’t change much when the industry expands or contracts.
49
Definition
Decreasing Cost Industry:An industry in which industry costs decrease with greater output; shown with a downward sloped supply curve.
50
Decreasing Cost Industry
Industry clusters can create decreasing cost industries.
As the industry grows, suppliers of inputs move into the area, decreasing costs.
Dalton Georgia – “Carpet Capital of the World” Silicon Valley – Computer technology
Cost reductions are temporary. Once the cluster is established, constant or
increasing costs are the norm.
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Industry Supply Curves
52
53
Self-Check
An industry where the industry costs do not change with greater output is called a(n):
a. Increasing cost industry.
b. Constant cost industry.
c. Decreasing cost industry.
Answer: b – constant cost industry.
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Takeaway
1. What price to set? • In a competitive industry, a firm sets its price
at the market price.
2. What quantity to produce? • To maximize profit, a competitive firm should
produce the quantity that makes P = MC.
55
Takeaway
3. When to exit and enter? • In the short run, the firm should shut down
only if price is less than average variable cost.
• In the long run, a firm should enter if P > AC and exit if P < AC.
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Takeaway
Profit maximization and entry and exit decisions are the foundation of supply curves.
In an increasing cost industry, costs rise so supply curves are upward-sloping.
In a constant cost industry, costs remain the same so the long-run supply curve is flat.
In the rare case of a decreasing cost industry, costs fall so supply curves are downward-sloping.