Managerial Decisions in Competitive Markets BEC Managerial Economics

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 D S Quantity Price (dollars) Quantity Price (dollars) P0P0 Q0Q0 Market Demand curve facing a price-taker 0 0 P0P0 D = MR

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 = π = TR - TC

In the short run, the firm incurs costs that are: – Unavoidable and must be paid even if output is zero – Variable costs that are avoidable if the firm chooses to shut down In making the decision to produce or shut down, the firm considers only the (avoidable) variable costs & ignores fixed costs Profit-Maximization in the Short-run

Profit Margin (or Average Profit) 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

Profit Maximization: P = $36

Panel A: Total revenue & total cost Panel B: Profit curve when P = $36 Profit Maximization: P = $36 Break-even point

Short-run Loss Minimization: P = $10.50 Total cost = $17 x 300 = $5,100 Total revenue = $10.50 x 300 = $3,150 Profit = $3,150 - $5,100 = -$1,950

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 π = (P – ATC)Q

Short-run Supply Curves For an individual price-taking firm – Portion of firm’s 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 – Supply prices give marginal costs of production for every firm

Short-run Firm & Industry Supply

Short-run Producer Surplus Short-run producer surplus is the amount by which TR exceeds TVC – The area above the short-run supply curve that is below market price over the range of output supplied – Exceeds economic profit by the amount of TFC

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 Profit-Maximizing Equilibrium Profit = ($17 - $12) x 240 = $1,200

Long-run Competitive Equilibrium

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

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

Long-run Industry Supply for a Constant Cost Industry

Long-run Industry Supply for an Increasing Cost Industry Firm’s output

Economic Rent Payment to the owner of a scarce, superior resource in excess of the resource’s opportunity cost In long-run competitive equilibrium firms that employ such resources earn zero economic profit – Potential economic profit is paid to the resource as economic rent – In increasing cost industries, all long-run producer surplus is paid to resource suppliers as economic rent

Economic Rent in Long-run Competitive Equilibrium