Third Edition Costs and Profit Maximization Under Competition · Third Edition Costs and Profit...

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

12

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


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


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


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).


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


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

34

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


� 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


� 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


� 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


� 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


53


54


55


56


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


we can also write

We then substitute:

59

Profit = TR – TC

TR = P x Q


we can also write

We can also substitute:

60

Profit = TR – TC

AC = TC / Q

( )Profit = x Q –P x Q Q

TC Q


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


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


� 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


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


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


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.


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


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

80


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.

88

Third Edition Costs and Profit Maximization Under Competition · Third Edition Costs and Profit...

Documents

Transcript of Third Edition Costs and Profit Maximization Under Competition · Third Edition Costs and Profit...