Post on 17-Apr-2020
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Costs and Profit Maximization Under Competition
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
The Big Questions
How do firms behave?
The assumption:
Profit is the main motivation for firms’ actions.
How do firms maximize profit?
By controlling their variables:
Price (if possible)
Quantity
Cost
3
The Big Questions
� 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.
4
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.
• Exist mostly in agriculture/commodities
5
What Price to Set?
PricePrice
Quantity(barrels)
Quantity(barrels)
Market
demand
Market
supply
$50
Demand
for one
firm’s oil
82,000,000
6
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.
7
Definition
Long run:
the time after all exit or entry has
occurred.
8
Short run:
the time period before exit or entry can
occur.
Self-Check
9
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).
10
Profit = π = Total Revenue – Total Cost
Definition
Total revenue:
price times quantity sold.
11
Total cost:
(market value of the inputs or opportunity) cost of producing a given quantity of output.
TR = P x Q
Economic Costs Defined
• Firms incur costs in the production process
• Land, labor, capital costs
• Accounting costs versus economic costs
• Accounting costs do not include opportunity costs
• Costs can be defined as either explicit and implicit
• Economic costs are what matter most
• Accounting costs = explicit costs
• Economic costs = explicit + implicit costs
• Difference is opportunity costs
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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.
• Opportunity Costs -The cost of something is what you give up to get it.
• This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
13
Definition
Explicit cost:
a cost that requires a money outlay.
14
Implicit cost:
a cost that does not require an outlay of money.
Definition
Accounting profit:
total revenue minus explicit costs.
15
Economic profit:
total revenue minus total costs including implicit costs.
Explicit vs Implicit Costs
Example:
You need $100,000 to start your business. The interest rate is 5%.
• Case 1: borrow $100,000
� explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings, borrow the other $60,000
� explicit cost = $3000 (5%) interest on the loan
� implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.
• In both cases, total (exp + imp) costs are $5000.16
Explicit vs Implicit Costs
Example:
Assume the firm’s revenues are $10,000
What are the firm’s accounting and economic profits?
Accounting profits (explicit costs only):
Case 1: $10,000 - $5,000 = $5,000 profit
Case 2: $10,000 - $3,000 = $7,000
Economic profits (expl + impl costs):
Case 1: $10,000 - $5,000 = $5,000 profit
Case 2: $10,000 - $5,000 = $5,000
Accounting profits do not reflect implicit costs or opportunity costs
17
Explicit vs Implicit Costs
18
Self-Check
19
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.
The Production Function
20
� The Production Function
• The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.
• A production function is a physical process – you take land, labor, raw materials, capital, energy, and other inputs to create a product (output)
• A production function is not a direct cost function, but cost functions are derived from production functions
The Production Function
21
� A production function tells you how much product (Q) you produce given a certain level of input(s)
� However, Economists are concerned with Marginal Product• The marginal product of any input in the production
process is the increase in output that arises from an additional unit of that input.
• In other words, what is the increase in Q (output) from a one unit increase in an input (labor, capital, etc).
The Production Function
22
� Diminishing Marginal Product• Diminishing marginal product is the property
whereby the marginal product of an input declines as the quantity of the input increases. � Example: As more and more workers are hired at a firm,
each additional worker contributes less and less to production because the firm has a limited amount of capital.
� Another example: adding fertilizer to a plot of land, first increments add a lot to output, further increments increase Q by lesser amounts, finally too much fertilizer can even cause Q to decline
Production Function and Total Cost: A Cookie Factory
23
Total Production Function
24
The Production Function
25
� Diminishing Marginal Product• The slope of the production function measures the
marginal product of an input, such as a worker.
• When the marginal product declines, the production function becomes flatter.
• Note that the axes of the production function graph are total product and quantity of input, no $dollars on either axis
• Fertilizer example – since higher increments of fertilizer additions yield less additional Q, this is described as diminishing marginal product
From the Production Functionto the Total Cost Curve
26
� Need to translate the production function (physical product) into a cost curve ($unit cost)
� Since production input costs are known, can determine total cost levels for each value of Q
� The relationship between the quantity a firm can produce and its costs determines pricing decisions.
� The total-cost curve shows this relationship graphically.
Production Functions and Marginal Costs
27
From the Production Functionto Marginal Costs
28
� Why does the total cost curve rise at the end?
� Diminishing marginal returns – i.e. more factor inputs required at this point causes greater costs for a diminishing increment increase in output (Q)
� i.e. adding one unit of labor increases costs by the same amount, however, less Q is produced by one more labor unit
� Thus, marginal cost increases with higher levels of output due to diminishing marginal product
Production Functions and Marginal Costs
29
� Equation for marginal costs:
� As output rises, incremental cost per unit (eventually) rises
� MC is used to determine profit maximization and many other types of analyses
� Ex) What’s the marginal cost of an additional student in this class?
MC = ����TC / ����Q
Costs of Production - Definition
Fixed costs:
are costs that do not vary with output.
Can’t be changed by short-run choices; should
be ignored in the short run.
Can be changed by long-run choices; should
be focused on in the long run.
30
Costs of Production - Definition
31
Variable costs:
costs that do vary with output.
Costs of Production
� Total costs = Fixed Costs + Variable Costs
� TC = FC + VC
� Fixed costs are those costs incurred when output (Q) is zero
• Consists of factors of production that are fixed for the short run, i.e. land, buildings, machinery, insurance, etc
• Fixed costs do not vary with output
• The firm faces fixed costs no matter what
� Variable costs are those costs that vary with output (Q)
• Labor costs, materials costs, energy costs, etc
• Variable costs equal zero when output is zero
• As output increases, variable costs increase32
Costs of Production - Example
• Example: Airline Costs
• What is the airline’s product (Q)?
� Passenger miles
� Note: Revenues = Price * Q
• Fixed costs – airplanes, buildings, maintenance facilities, land, insurance, etc.
• Variable costs - aviation fuel, pilot costs, other expenses related to actually flying the planes, producing passenger miles
�To spread fixed costs, must keep airplanes in the air as much as possible (Southwest)
33
Maximizing Profit
�
� 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.
� But first a discussion of “evil” profits
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And Now a Word About Profits
� “Capitalism without losses is like Religion without Hell.” – Frank Borman
� "I don't tell my grocery when I am coming. I don't tell the grocery what I am going to buy. I don't tell my grocery how much I am going to buy, but if they don't have what I want when I get there, I fire them.” - Walter Williams
� https://www.youtube.com/watch?v=tdHwewUuXBg
35
36
Fortune 500 Turnover
And Now a Word About Profits
� Markets require Profits and Losses as a signal to producers
� Without profits/losses massive waste and inefficiency will result
� Why are profits considered evil?
• Consumers pay prices that are too high?
• Profits are “unfairly” high?
• Profits lead to income inequality?
• Marx’s contention that “surplus value” should go to
labor?
� Profits from “Krony Kapitalism” most likely “evil”
37
And Now a Word About Profits
� Profits/losses exist in any type of economy,
� Even for Cuba, N. Korea, Venezuela, whether they realize it or not (or care to admit it)
� Profits are signals to entrepreneurs or owners as to the viability of their investments and their skill as owners/managers
� Consumers are “sovereign” – their buying choices ultimately determine success/failure of firms
� For Competitive Industries:
� “Market Discipline” – inefficient firms are ruthlessly squashed by competition
� “Mr. Market” always wins…..38
And Now a Word About Profits
� Firms must be allowed to fail in order to “educate” themselves and the market, so as to allocate scarce resources to their highest valued use
� Profits are a “learning experience” as well
� Markets reward innovation, good customer service
� Higher than normal profit levels will attract new firms, eventually causing prices, revenues, and profits to fall – solves the problem of excess profits (even in the LR for monopolies)
� 39
And Now a Word About Profits
� Implication: wherever possible, promote competitive markets rather than enacting “windfall” profit taxes or government regulation
� No surprise - business owners hate competition
� Consumers love competition between firms
� Crony Capitalism – legislation designed to reduce competition and enhance profits
40
Maximizing Profit
� Rather than use:
� 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.
41
Definition
Marginal revenue (MR):
the change in total revenue from selling an additional unit.
42
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 = MR = Price.
43
Self-Check
44
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).
Definition
Marginal cost (MC):
the change in total cost from producing an additional unit.
45
Maximizing Profit
=
Maximizing Profit
P($/barrel)
Quantity(barrels)0 102 3 4 5 6 7 8 91
100
$150
50
0
MR = P
At a Quantity of 8,
MR = MC
Profits are maximized
WorldMarketprice
47
Marginalcost
More profit More profit
Maximizing Profit
� As the price changes, so does the profit-maximizing quantity.
� If price increases, the firm will expand production.
� Will continue to expand until it is once again maximizing profit where P = MC.
48
Maximizing Profit
P($/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
49
Self-Check
50
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.
51
AC = TC / Q
Cost Concepts - Equations
� Starting with TC = FC + VC
� Divide by Q to get averages:
• AC = AFC + AVC
• AFC = FC/Q
• AVC = VC/Q
• AC = TC/Q
� Average cost concepts much easier to interpret in graphical format
� Much easier to understand profit maximization conditions graphically
52
Cost Concepts - Equations
53
Cost Concepts - Equations
54
Cost Concepts - Equations
55
Cost Concepts - Equations
56
Cost Concepts - Equations
57
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.
58
( )Profit = x Q – TC Q
TR Q
Profits and the Average Cost Curve
we can also write
We then substitute:
59
Profit = TR – TC
TR = P x Q
Profits and the Average Cost Curve
we can also write
We can also substitute:
60
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:
61
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).
62
Profit = (P – AC) x Q
Profits and the Average Cost Curve
� Profit = Q * (P – ATC) � is the most useful form of profit equation
� When P >ATC � profits are positive
� When P < ATC � losses occur (profits < 0)
� and if P = ATC � profits are zero
�Since a firm in a competitive market must sell its output at the market price, profit maximization depends only on the firm’s output decision
63
Profits and the Average Cost Curve
64With 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
65
• 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)
66
17
Price = 10Loss
Marginalcost
Cost = 20
Maximizing Profit
Price
Quantity0 102 3 4 5 6 7 8 91
$100
50
0
AverageCost (AC)
67
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
Profit Maximization Method
68
1. Find that Q (output) where MC = MR
2. Determine value of AC at that Q
3. Calculate profits using the formula:
Profit = Q * (P – ATC)
Self-Check
69
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
70
� 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, economic 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.
• If firms in the industry average 5%, that would be normal profits
Entry, Exit, and Shutdown
71
� 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, i.e. if the firm cannot cover its variable
costs
TC = VC + FC
Entry, Exit, and Shutdown
72
� 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 (long run) 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
73
The firm’s entry, exit, and shutdown decisions.
Entry, Exit, and Industry Supply
74
� Entry of firms – shifts the industry supply curve
outwards
� Exit of firms – shifts the industry supply curve
inwards
� 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.
75
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.
76
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 77
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.
78
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.
79
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
80
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.
81
Definition
Decreasing Cost Industry:
An industry in which industry costs decrease with greater output; shown with a downward sloped supply curve.
82
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.
83
Industry Supply Curves
84
Self-Check
85
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.
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.
86
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.
87
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.
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