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.

11

Definition

Explicit cost:

a cost that requires a money outlay.

12

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.

14

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.

15

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.

17

Definition

Marginal revenue (MR):

the change in total revenue from selling an additional unit.

18

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.

19

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.

24

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.

27

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.

28

( )Profit = x Q –

TC Q

TR Q

Profits and the Average Cost Curve

we can also write

We then substitute:

29

Profit = TR – TC

TR = P x Q

Profits and the Average Cost Curve

we can also write

We can also substitute:

30

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:

31

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).

32

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

34

• 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.

44

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

qQ

$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.

51

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.

54

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.

56

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.