The Competitive Firm Chapter 7

In this Chapter Market Structure 7.2. Profit Maximization for A firm in Perfectly Competitive Market 7.3. When to Shutdown; and the Supply Curve of a Competitive firm

The Profit Motive The basic incentive for producing goods and services is the expectation of profit. Profit is the difference between total revenue and total cost.

Other Motivations Personal reasons also motivate producers. Producers seek social status and crave recognition. Non-owner managers of corporations may be more interested in their own jobs, salaries, and self-preservation than earning profits for stockholders.

Is the Profit Motive Bad? The profit motive encourages businesses to produce the goods and services consumers’ desire, at prices they are willing to pay.

What Proportion of the Sales Price, do you think, goes to Sellers (Producers) as Profit? The typical consumer believes that 35¢ of every sales dollar goes to profits. In reality, average profit per sales dollar is closer to 5¢.

Economic and Accounting Profits Economic profit is the difference between total revenues and total economic costs. Economic cost is the value of all resources used to produce a good or service – opportunity cost.

To determine a firm’s economic profit, all implicit factor costs must be subtracted from observed accounting profit. Economic and Accounting Profits

Economic profits represent something over and above normal profits. Normal profit is the opportunity cost of capital A productive activity reaps an economic profit only if it earns more than its opportunity cost.

Economic Profits

Entrepreneurship The inducement to take on the added responsibilities of owning and operating a business is the potential for profit. The potential for profit is not a guarantee of profit. 1. substantial risks are attached to starting and operating a business. 2. The opportunity for profit may be limited by the structure of the industry.

7.1. Market Structure

Market Structure Market structure refers to the number and relative size of firms in an industry. Two broad Categories 1. Perfectly Competitive 2. Imperfectly Competitive

Market Structure Oligopoly Duopoly MonopolyMonopolistic competition I. Perfect Competition II. Imperfect competition

I. The Nature of Perfect Competition Distinguishing characteristics: Many firms – lots of firms are competing for consumer purchases. Identical products – the products of the different firms are identical, or nearly so. Low entry barriers – it’s relatively easy to get into the business. Perfect Information-Every body knows every thing about the market

Market Structure Perfect competition is a market in which no buyer or seller has market power.

Price Takers A perfectly competitive firm has no market power and thus has no ability to alter the market price of the goods it produces. Market Power – The ability to alter the market price of a good or service.

Price Takers The output of a perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market. Pricing decision is thus beyond the control of the firm The firm has to decide on how much to produce

Market Demand Curves vs. The Demand Curves Facing A Firm

It is important to distinguish between the market demand curve and the demand curve confronting a particular firm.

Market Demand Curves vs. Firm Demand Curves The market demand curve for a product is always downward-sloping. The market demand curve for a product is always downward-sloping.

PRICE (per shirt) Quantity (thousand shirts per day) Market Demand Curves vs. Firm Demand Curves Market demand Market supply Equilibrium price pepe The T-shirt market

Market Demand Curves vs. Firm Demand Curves The market demand curve for a product is always downward-sloping. However, the demand curve confronting a perfectly competitive firm is horizontal

Quantity (shirts per day) Demand facing one shop PRICE (per shirt) Quantity (thousand shirts per day) Market Demand Curves vs. Firm Demand Curves Market demand Market supply Equilibrium price pepe The T-shirt market pepe Demand facing single firm

The Production Decision Thus a competitive firm has only one decision to make: how much to produce. The production decision is the selection of the short-run rate of output (with existing plant and equipment).

Output and Revenues In searching for the most desirable rate of output, the distinction between total revenue and total profit must be kept in mind. Total revenue - The price of the good multiplied by the quantity sold in a given time period. Total revenue = price X quantity

Output and Revenues Total Revenue: PXQ Total Revenue Curve an upward-sloping straight line The Slope of The TR Curve: p e.

Total revenue p e = $ $96 Quantity Total Revenue

Output and Costs To maximize profits a firm must consider how increased production will affect costs as well as revenues. Producers are saddled with certain costs in the short-run. Short-run - The period in which the quantity (and quality) of some inputs cannot be changed.

Output and Costs – Fixed costs - Costs of production that do not change when the rate of output is altered, e.g., the cost of basic plant and equipment. Fixed costs are incurred even if no output is produced. -Variable costs - Costs of production that change when the rate of output is altered, e.g. labor and material costs. Once a firm starts producing output, it incurs variable costs as well.

Total Cost (dollars per time period) Output (units per time period) Total Cost z Total cost Fixed cost Total costs escalate due to the law of diminishing returns

Output and Costs The shape of the total cost curve reflects increasing marginal costs and the law of diminishing returns. Marginal cost is the increase in total costs associated with a one-unit increase in production.

Output and Costs Given these conditions, the producer’s problem is to find that one particular rate of output that maximizes profits.

Output (units per period) Revenues Or Costs (dollars per period) Total Profit Total costTotal revenue Profits Losses r s fhg

Profit-Maximizing Rule The best single rule for maximizing short-run profits is … To never produce a unit of output that costs more than it brings in. What does this means?

Profit-Maximizing Rule The producer has to compare the contribution of the additional unit of the output to the total revenue with the what it costs to produce that additional unit. The contribution to total revenue of an additional unit of output is called marginal revenue.

Profit-Maximizing Rule Marginal revenue (MR) is the change in total revenue that results from a one- unit increase in the quantity sold. In a perfectly competitive market, MR is simply the price of the product; MR=P

Marginal Revenue = Price

Marginal Cost We know that, for a firm in perfectly competitive market, the price of its product is its marginal revenue. The firm’s goal is not to maximize revenues, but to maximize profits….To achieve this goal.. … the firm has to compare its Marginal Revenue with its Marginal Costs and determine the best level of output.

Marginal Cost Recall: Just as what an additional unit of output brings in is the firms marginal revenue (MR); Marginal cost is what it costs the firm to produce the additional unit of the output

Marginal Cost

Profit-Maximizing Output a firm should produce at that rate of output where marginal revenue equals marginal cost. Max Profit: MR=MC As MR=P; the Profit maximizing Rate of output is one that can be produced when marginal cost equals the price of the product P= MC

Profit-Maximizing Output If marginal cost exceeds price, total profits decline if the additional output is produced. If marginal cost is less than price, total profits increase if the additional output is produced. Profits are maximized at the rate of output where price equals marginal cost.

Short-Run Profit-Maximization Rules for Competitive Firm Price > MC  increase output Price = MC  maintain output and maximize profit Price < MC  decrease output

Quantity (bushels per day) $18 Price or Cost (per bushel) Marginal cost Price (= MR) Profit-Maximizing Rate of Output Profit-maximizing rate of output MC B MR B p = MC Profits decreasing Profits increasing

Adding Up Profits Profits can be computed in two ways. 1. As a difference between total revenue and total cost. Total profit = total revenue – total cost

Adding Up Profits 2.As a difference between Price and average total cost times the number sold. Profit per unit = price – ATC Total profit = (p – ATC) X q

Alternative Views of Total Profit $18 Rate of Output Price or Cost (per unit) Price and average cost Profit per unit Marginal cost Total Profit Price Average total cost Cost per unit Revenue or Cost (dollars per day) Total revenue Maximum total profit Total cost $90 Rate of Output Total revenue and total cost

Implication… The profit-maximizing producer has no desire to produce at that rate of output where ATC is at a minimum. I.e., profit max output is not necessarily at the point where ATC is the lowest.

The Shutdown Decision In a competitive market, the short-run profit maximization rule does not guarantee any profits. It tells the output level that maximizes economic profit. A firm in such a market thus always want to produce that level of output. However, a competitive market is characterized by free entry (lack of barriers to entry).

The Shutdown Decision Economic profits being made by firms already in the market will attract new (more) firms into that business. Entry of new firms into the market will affect the market supply and thus market price of the good. As a result, it possible that a firm already in the market could face and economic loss. When should it shutdown the business?

The Shutdown Decision A firm should shut down only if the losses from continuing production exceed fixed costs. It is possible to run a business while incurring losses, as long as the loss doesn’t exceed the fixed cost

The Shutdown Point However, when price does not cover average variable costs at any rate of output, production should cease. The shutdown point is that rate of output where price equals minimum AVC.

Open 24 Hours, 7 days a week When price exceeds average variable cost but not average total cost, the profit maximizing rule minimizes losses. Think of the Opening and Closing hours of businesses! Some business shutdown after 10Pm other stay open 24 hours. If MR from sales during later hours pays for the variable cost of staying open…stay open Other wise shutdown

The Shutdown Point Loss Quantity MC AVC ATC Price Y Shutdown Quantity MC AVC ATC Price shutdown point Profit Price or Cost Quantity MC AVC ATC X Price (=MR )

The Firm’s Supply Curve In the short run, the firms supply curve is the portion of its MC curve which lies to the right of the shutdown point. The portion of it marginal cost curve that lies to the right of the point where P=MR=AVC

Short-Run Supply Curve $18 Quantity Supplied (bushels per day) Price (per bushel) Marginal cost curve Short-run supply curve for competitive firm = Y X Shutdown point Why is Supply curve upward slopping?

Short-Run Supply Curve The marginal cost curve is the short-run supply curve for a competitive firm. Supply curve – A curve describing the quantities of a good a producer is willing and able to sell (produce) at alternative prices in a given time period, ceteris paribus.

Determinants of Supply The quantity of a good supplied is affected by all forces that alter marginal cost. These include: The price of factor inputs. Technology (the available production function). Expectations (for costs, sales, technology). Taxes and subsidies.

Supply Shifts If any determinant of supply changes, the supply curve shifts. E.g. Tax Effects: Property Taxes Payroll Taxes Profit Taxes

Property Taxes Property taxes are a fixed cost. They raise average costs and reduce profit. However, they don’t affect marginal costs. Thus they leave the profit- maximizing output unchanged.

Payroll Taxes Payroll taxes increase marginal costs. They reduce the profit maximizing rate of output. Thus they increase not only the average costs but also lower the total and per-unit profits. Thus altering the profit maximizing output level

Profit Taxes Profit taxes are neither a fixed cost nor a variable cost. They don’t affect marginal cost or prices. They don’t affect production level decisions but may affect investment decisions.

Impact of Taxes on Business Decisions pepe q1q1 MC 1 ATC a ATC 1 Property taxes affect fixed costs pepe q1q1 MC 1 ATC b ATC 1 MC b qbqb Payroll taxes alter marginal costs pepe MC 1 ATC 1 q1 Profits taxes don't change costs