Market Structure
Managerial Decisions in Perfect
Competition
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
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
Demand for a Competitive
Price-Taking Firm (Figure 11.2)
S
Price (dollars)
Price (dollars)
P0 P0
D = MR
D
0 Q0 0
Quantity Quantity
Panel A – Panel B – Demand curve
Market facing a price-taker
Dynamics of equilibrium in PC
• If all firms make profits. Because of free
entry other firms enter the industry and
prices decrease till only Normal profits are
there.
• If firms make losses, firms exit and Price
increases till normal profits are made.
• Thus in the long run no profit or loss- only
Normal Profit ( Economic Profit).
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
Profit = TR TC
Profit Margin (or Average
Profit) )Q
( P ATC
Average profit
Q Q
P ATC Profit margin
• 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
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
Profit Maximization: P = $36
(Figure 11.3)
Total revenue =$36 x -600
Profit = $21,600 $11,400
= $21,600
= $10,200
Total cost = $19 x 600
= $11,400
Profit Maximization: P = $36
(Figure 11.4)
Panel A: Total revenue
& total cost
Panel B: Profit curve
when P = $36
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)
Profit = $3,150 x 300
Total cost = $17 - $5,100
= -$1,950
= $5,100
Total revenue = $10.50 x 300
= $3,150
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
Summary of Short-Run Output
Decision
• 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
• ( P ATC )Q
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
Derivation of Short-Run Supply
Curves (Figure 11.6)
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)
Profit = ($17 - $12) x 240
= $1,200
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
Long-Run Competitive
Equilibrium (Figure 11.8)
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
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
Long-Run Industry Supply for a
Constant Cost Industry (Figure
11.9)
Long-Run Industry Supply for an
Increasing Cost Industry (Figure
11.10)
Firm’s output
Profit-Maximizing Input Usage
• Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit
Labour Market-
• Firms employ labour and capital because
they want to maximise profits.
• Profit = R(X)-C(X)
• = P(X).X- wL- rK
• Due to diminishing returns, some
contribute more than the wages they
receive.
• These labour contribute to the firm owner’s
Profit.
MPL 1100
M Wages are 400
P
L 900
What are profits made at different
wage levels?
750
450
300
200
100
L
MPL L1 workers are employed at
W1 wages
PROFIT
W1
Wage Bill
MPL
L1 L
PROFITS OF FIRMS
• W1L1 is the wage bill.
• Profit is the difference between the output
and the wages.
• Profits are maximised when firms employ
workers upto the point their MPL = to
wages.
• The reason for this is the diminishing
marginal productivity of labour.
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
TR
MRP P MP
L
• 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
Equating Marginal Revenue and
Marginal Cost
• The importance of equating marginal
revenue and marginal costs for
maximizing profits is straightforward.
• As long as the marginal revenue derived from
expanded output exceeds the marginal cost of
that output, the expansion of output creates
additional profits.
• However, expansion of output when the
marginal cost of production exceeds marginal
revenue will lead to losses on the additional
output, decreasing profits.
• Total revenues and total costs and the
profit-maximizing output rule give the
same result.
11.4 Short-Run Profits
and Losses
• Producing at the profit-maximizing output
level does not mean that a firm is actually
generating profits.
– It merely means that a firm is maximizing its
profit opportunity at a given price level.
– A firm could be
• earning profits
• generating losses
• breaking even
The Three-Step Method
• Three easy steps to determine economic profits,
economic losses, or zero economic profits:
– Where MR equals MC proceed down to horizontal
axis to find q*, the profit-maximizing output level.
– At q*, go straight up to demand curve, then to
price axis to find the market price, P*.
– Now you can find TR at the profit-maximizing
output level because TR = P x q.
• The last step is to find total costs.
• Go straight up from q* to the short-run
average total cost (SRATC) curve; this will
give you the average cost per unit.
• If we multiply average total costs by the
output level, we can find the total costs
(TC = ATC x q).
• If TR > TC at the profit-maximizing output level,
the firm is generating economic profits.
• If TR < TC, the firm is generating economic
losses.
• If TR - TC, the firm is earning zero economic
profits,
– Covering both implicit and explicit costs,
economists sometimes call zero economic
profit a normal rate of return.
P* = $6
ATC = $5
Evaluating Economic Losses
in the Short Run
• A firm generating an economic loss faces
a tough choice:
– Should it continue to produce or
– shut-down its operation?
• To make this decision, we need to
consider average variable costs.
• If a firm cannot generate enough revenues
to cover its variable costs, then it will have
larger losses if it operates than if it shuts
down
– (losses in that case = fixed costs).
– Thus, a firm will not produce at all unless the
price is greater than its average variable
costs.
• At price levels greater than or equal to
average variable costs, a firm may continue
to operate in the short run even if average
total costsvariable and fixed costsare
not completely covered.
– Because fixed costs continue whether the firm
produces or not, it is better to earn enough to
cover a portion of these costs rather than earn
nothing at all.
• When price is less than average total
costs but more than average variable
costs, the firm produces in the short run,
but at a loss.
– To shut down would make this firm worse off
because it can cover at least some of its fixed
costs with the excess
of revenue over its variable costs.