Costs and Profit Maximization Under Competition Chapter 11 Costs and Profit Maximization Under Competition

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

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

Individual Firm’s Demand What Price to Set? World Market For Oil Individual Firm’s Demand Price Price Market supply Demand for one firm’s oil $50 Market demand 82,000,000 Quantity (barrels) 2 5 10 Quantity (barrels)

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.

Definition Long run: Short run: the time after all exit or entry has occurred. Short run: the time period before exit or entry can occur.

Self-Check In a perfectly competitive market, a firm will set its price: Equal to its cost of production. Equal to its costs plus a normal markup. 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). Profit = π = Total Revenue – Total Cost

Definition Total revenue: Total cost: TR = P x Q price times quantity sold. TR = P x Q Total cost: cost of producing a given quantity of output.

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.

Definition Explicit cost: Implicit cost: a cost that requires a money outlay. Implicit cost: a cost that does not require an outlay of money.

Definition Accounting profit: Economic profit: total revenue minus explicit costs. Economic profit: total revenue minus total costs including implicit costs.

Self-Check Economic profit is total revenue minus: Explicit costs. Implicit costs. Both explicit and implicit costs. Answer: c – Economic profit equals total revenue minus both explicit and implicit costs.

Definition Fixed costs: Variable costs: costs that do not vary with output. Variable costs: costs that do vary with output.

Maximizing Profit TC = FC + VC 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. 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.

Definition Marginal revenue (MR): MR = TR / Q the change in total revenue from selling an additional unit. 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.

Definition Marginal cost (MC): the change in total cost from producing an additional unit.

Self-Check A competitive firm will maximize its profit at the quantity: Where MR = Price. Where MR = MC. 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 Figure 11-2 (11-2): Profit Is Maximized by Producing until MR = MC =

Maximizing Profit At a Quantity of 8, MR = MC Profits are maximized P ($/barrel) $150 At a Quantity of 8, MR = MC Profits are maximized Marginal cost 100 More profit More profit World Market price 50 MR = P Quantity (barrels) 1 2 3 4 5 6 7 8 9 10

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.

Maximizing Profit P ($/barrel) As Price increases, the firm expands production along its MC curve $150 Marginal cost $100 MR = P World Market price $50 MR = P Quantity (barrels) 1 2 3 4 5 6 7 8 9 10

Self-Check If price increases, a firm will: Expand production. Decrease production. Price does not affect how much a firm produces. Answer: a – if price increases, a firm will expand production.

Definition Average Cost of Production: AC = TC / Q the cost per unit, or the total cost of producing Q units divided by Q. 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.

Profits and the Average Cost Curve we can also write We then substitute: Profit = TR – TC ( ) Profit = x Q – TC Q TR Q TR = P x Q

Profits and the Average Cost Curve we can also write We can also substitute: Profit = TR – TC ( ) P x Q Q TC Q Profit = – x Q AC = TC / Q

Profits and the Average Cost Curve we can also write We end up with: Profit = TR – TC ( ) P x Q Q Profit = – AC x Q Profit = (P – AC) x Q

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). Profit = (P – AC) x Q

Profits and the Average Cost Curve Figure 11-4 (11-4): Profit = (P – AC) × Q With an average cost curve, we can show profits on a graph.

Maximizing Profit Profits are maximized at MR = MC, where Q = 8 Price Profits are maximized at MR = MC, where Q = 8 At Q = 8, AC = $25.75 Profit = (P – AC) x Q Marginal cost $100 Average Cost (AC) 50 MR = P Profit = (50-25.75) x 8 = $194 25.75 1 2 3 4 5 6 7 8 9 10 Quantity

Maximizing Profit MR = MC doesn’t mean the firm makes a profit Price MR = MC doesn’t mean the firm makes a profit Minimum AC is $17 At any price below $17, P < AC → Losses Marginal cost $100 Average Cost (AC) 50 MR = P Cost = 20 17 Loss Price = 10 1 2 3 4 5 6 7 8 9 10 Quantity

The MC curve crosses the AC curve at its minimum point Maximizing Profit Price Marginal cost $100 The MC curve crosses the AC curve at its minimum point Average Cost (AC) 50 P = MC < AC is a loss P = MC > AC is a profit 17 1 2 3 4 5 6 7 8 9 10 Quantity

Self-Check If a firm produces at the output where MR = MC, it will always make a profit. True. False. Answer: b – False; if average cost is greater than price, the firm will have a loss.

Entry, Exit, and Shutdown 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 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 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 The firm’s entry, exit, and shutdown decisions.

Entry, Exit, and Industry Supply 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.

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 SIndustry P Firm 1 MC1 P Firm 2 P Industry MC2 $50 AC2 AC1 $29 $17 q1 4 6 8 5 7 q2 4 11 15 Q P < $17 → Q = 0 P = $17 → Q = q1 + q2 = 4 P = $29 → Q = q1 + q2 = 11 P = $50 → Q = q1 + q2 = 15

Definition Constant Cost Industry: An industry in which industry costs do not change with greater output; shown with a flat supply curve.

Constant Cost Industry A constant cost industry has two characteristics: 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. 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 P P Market Firm SSA MC B SSB B $7.99 AC C LRS C $6.99 A A DB DA q Q QA QB QC qA qB ↑ Market demand → ↑ market price → ↑ profits ↑ profits → Existing firms ↑ q → ↑ Q ↑ profits → Firms enter → Short-run supply shifts right → ↓ P, ↑Q Profits return to normal

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.

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 Figure 11-9 (11-9): Increasing Cost, Constant Cost, and Decreasing Cost Industries 52

Self-Check An industry where the industry costs do not change with greater output is called a(n): Increasing cost industry. Constant cost industry. Decreasing cost industry. Answer: b – constant cost industry.

Takeaway What price to set? In a competitive industry, a firm sets its price at the market price. What quantity to produce? To maximize profit, a competitive firm should produce the quantity that makes P = MC.

Takeaway 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.

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.