McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 11: Managerial Decision in Competitive Markets

Managerial Economics 11-2 Perfect Competition (P.C. Mkt) Many buyers and sellers; no one is large enough to influence the market price Perfect information of market price; buyers and sellers are price-takers All firms produce a homogeneous product; no quality difference Entry into & exit from the market is unrestricted in the long run; number of sellers can change in the long run. Dr. Chen’s notes: There are only few markets qualified as P.C. mkt: agricultural products and stock market. The toughest market characteristic to be satisfied is the perfect price information.

Managerial Economics 11-3 Demand facing a P.C. firm Demand curve facing a P.C. firm is horizontal at price determined by intersection of market demand & supply Perfectly elastic Marginal revenue equals market price Demand curve is also marginal revenue curve (P = MR) Can sell all they want at the market price Each additional unit of sales adds to total revenue an amount equal to price (MR = P) Dr. Chen’s notes: The concept here can be understood by studying the graphs on the next slide. In Panel A, the determined market price P 0 is the unit price facing a firm. To a firm, the demand curve is just the horizontal market price line in Panel B. A firm can sell all its productions at the market price.

Managerial Economics 11-4 D S Quantity Price (dollars) Quantity Price (dollars) P0P0 Q0Q0 Panel A – Market Panel B – Demand curve facing a price-taker Demand for a Competitive Price-Taking Firm (Figure 11.2) 0 0 P0P0 D = MR

Managerial Economics 11-5 Profit-Maximization in the Short Run In the short run, managers must make two decisions: 1.Produce or shutdown?  If shutdown, produce no output (Q=0) and hires no variable inputs  If shutdown, firm still needs to pay the fixed cost 2.If produce, what is the optimal output level?  Choose the optimal output Q* that maximizes economic profit

Managerial Economics 11-6 Short-Run Shutdown Decision If price is less than or equal to average variable cost (P ≤ AVC), then manager will shut down The largest possible loss for a firm in SR is its fixed costs Shutdown price is minimum AVC Dr. Chen’s notes: Why? Let’s rewrite the economic profit as the following:  = TR  TC = P*Q  (TVC + TFC) = P*Q  TVC  TFC = P*Q  AVC*Q  TFC,  = Q*(P  AVC)  TFC If P > AVC; that is, (P  AVC) > 0, then production (Q > 0) will contribute positively in profit. On the other hand, if P ≤ AVC, then Q = 0 (shutdown) will be the best choice. The largest possible loss is limited at its fixed cost as the following:  = Q*(P  AVC)  TFC = 0*(P  AVC)  TFC =  TFC

Managerial Economics 11-7 Short-Run Optimal Output Decision If a firm chooses to produce, then the optimal output will be decided by the rule of thumb: MR = MC For a P.C. firm, its marginal revenue is equal to the market price. Therefore, the rule of thumb becomes P = MC Dr. Chen’s notes: In graph, we can find the optimal output at the intersection of market price line (P=MR) and the firm’s marginal cost curve (SMC). Please check the next slide.

Managerial Economics 11-8 Total revenue =$36 x 600 = $21,600 Profit = $21,600 - $11,400 = $10,200 Total cost = $19 x 600 = $11,400 Profit Maximization: P = $36 (Figure 11.3)

Managerial Economics 11-9 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

Managerial Economics 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

Managerial Economics 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 Summary of Short-Run Output Decision

Managerial Economics Short-Run Supply Curves For a P.C. firm Portion of firms’ marginal cost (MC) curve above minimum AVC For prices below minimum AVC, quantity supplied is zero (shutdown) For a competitive industry Horizontal summation of MC curves of all firms; always upward sloping Dr. Chen’s notes: In a competitive market, an existing firm’s SR supply curve is its MC curve which is above the AVC curve.

Managerial Economics Long-Run Competitive Equilibrium All firms are in profit-maximizing equilibrium (P = LMC) Each existing firm only earns a zero economic profit (i.e. normal profit) because market price will be equal to the minimum ATC of firms (P = LMC = Minimum ATC) Dr. Chen’s notes: Why P = Minimum ATC in the long run? If an existing firm can earn a positive profit; that is, P > ATC, then the industry is quite profitable to attract more entrants. New entrants will shift the market supply to the right because supply increases in the number of sellers. As a result, the market equilibrium price will continue to decline until all existing firms only earn a normal profit in which no new firm is willing to enter. The graph on the next slide shows the long-run equilibrium.

Managerial Economics Long-Run Competitive Equilibrium (Figure 11.8)

Managerial Economics Profit-Maximizing Input Usage Profit-maximizing level of input usage produces exactly that level of output that maximizes profit (Duality in firm’s behavior) Dr. Chen’s notes: In economics, MR=MC in output determination implies another rule of thumb for input determination. A firm has to pay for labor and capital inputs; therefore, the marginal cost (MC) is related to the price of input, such as wage and interest rate. On the other hand, the marginal revenue (MR) also depends on the marginal product of input. Let’s start from the optimal Q* which satisfies MR=MC MR =  TR /  Q =  TC /  Q = MC Let’s time MP L =  Q /  L on both sides: MR * MP L =(  TR /  Q)* (  Q /  L)= (  TC /  Q)* (  Q /  L) = MC* MP L MR * MP L =  TR /  L =  TC /  L = MC* MP L (Marginal Revenue Product of labor) MRP L = Wage (Price of unit labor)

Managerial Economics 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 MRP =  TR/  Input = MR*MP For a P.C. firm, MRP = MR*MP = P*MP Rule of Thumb Employ amount of input where MRP = input price For labor input (L), the optimal input usage should satisfy MRP L = w (wage). If MRP L > w, the manager should hire more labor. For capital input (K), MRP K = r (interest rate).

Managerial Economics Implementing the Profit- Maximizing Output Decision Step 1: Forecast product price Use statistical techniques from Chapter 7 Step 2: Estimate AVC & SMC

Managerial Economics Implementing the Profit- Maximizing Output Decision Step 3: Check shutdown rule If P > AVC min then produce If P ≤ AVC min then shut down To find AVC min substitute Q min into AVC equation

Managerial Economics Implementing the Profit- Maximizing Output Decision Step 4: If P  AVC min, find output where P = SMC Set forecasted price equal to estimated marginal cost & solve for Q *

Managerial Economics Implementing the Profit- Maximizing Output Decision Step 5: Compute profit or loss Profit = TR - TC Dr. Chen’s notes: In the SR, a firm will continue to operate when P > AVC. It might come with a negative profit (i.e. loss) when (P  AVC)Q < TFC. However, if a negative profit continues in the long run, what will the firm do? Quit! That is, not only shutdown (i.e. still paying the fixed cost) but leave the industry.