1. Chapter 11 Managerial Decisions in Competitive Markets

2. Learning Objectives
Discuss 3 characteristics of perfectly competitive markets
Explain why the demand curve facing a perfectly competitive firm is perfectly elastic and serves as the firm’s marginal revenue curve
Find short‐run profit‐maximizing output, derive firm and industry supply curves, and identify producer surplus
Explain characteristics of long‐run competitive equilibrium for a firm, derive long‐run industry supply, and identify economic rent and producer surplus
Find the profit‐maximizing level of a variable input
Employ empirically estimated values of market price, average variable cost, and marginal cost to calculate profit‐maximizing output and profit

3. 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

4. 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

5. Demand for a Competitive Price-Taking Firm (Figure 11.2)S
Price (dollars) D
Price (dollars) P0 P0
D = MR Q0
Quantity
Quantity
Panel A – Market
Panel B – Demand curve facing a price-taker

6. Profit-Maximization in the Short Run
In the short run, managers must make two decisions:
Produce or shut down?
If shut down, produce no output and hires no variable inputs
If shut down, firm loses amount equal to TFC
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

7. Profit-Maximization in the Short Run
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

8. 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

9. Short-Run Output Decision
Firm will produce output where P = SMC as long as:
Total revenue ≥ total avoidable cost or total variable cost (TR  TVC)
Equivalently, the firm should produce if P  AVC

10. Short-Run Output Decision
The firm will shut down if:
Total revenue cannot cover total avoidable cost (TR < TVC) or, equivalently, P  AVC
Produce zero output
Lose only total fixed costs
Shutdown price is minimum AVC

11. Fixed, Sunk,& Average Costs
Fixed, sunk, & average costs are irrelevant in the production decision
Fixed costs have no effect on marginal cost or minimum average variable cost—thus optimal level of output is unaffected
Sunk costs are forever unrecoverable and cannot affect current or future decisions
Only marginal costs, not average costs, matter for the optimal level of output

12. Profit Maximization: P = $36 (Figure 11.3)

13. Profit Maximization: P = $36 (Figure 11.3)

14. Profit Maximization: P = $36 (Figure 11.4)
Break-even point
Panel A: Total revenue & total cost
Break-even point
Panel B: Profit curve when P = $36

15. Short-Run Loss Minimization: P = $10.50 (Figure 11.5)
Total cost = $17 x = $5,100
Profit = $3,150 - $5, = -$1,950
Total revenue = $10.50 x = $3,150

16. 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

17. 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

18. 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

19. Computing Short-Run Producer Surplus (Figure 11.6)

20. Short-Run Firm & Industry Supply (Figure 11.6)

21. Long-Run Profit-Maximizing Equilibrium (Figure 11.7)
Profit = ($17 - $12) x 240 = $1,200

22. 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

23. Long-Run Competitive Equilibrium (Figure 11.8)

24. 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

25. 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

26. Long-Run Industry Supply for a Constant Cost Industry (Figure 11.9)

27. Long-Run Industry Supply for an Increasing Cost Industry (Figure 11
Firm’s output

28. 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

29. Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11)

30. Profit-Maximizing Input Usage
Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

31. 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
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

32. Profit-Maximizing Input Usage
Average revenue product (ARP)
Average revenue per worker
Shut down in short run if ARP < MRP
When ARP < MRP, TR < TVC

33. Profit-Maximizing Labor Usage (Figure 11.12)

34. Implementing the Profit-Maximizing Output Decision
Step 1: Forecast product price
Use statistical techniques from Chapter 7
Step 2: Estimate AVC & SMC
AVC = a + bQ + cQ2
SMC = a + 2bQ + 3cQ2

35. Implementing the Profit-Maximizing Output Decision
Step 3: Check shutdown rule
If P  AVCmin then produce
If P < AVCmin then shut down
To find AVCmin substitute Qmin into AVC equation

36. Implementing the Profit-Maximizing Output Decision
Step 4: If P  AVCmin, find output where P = SMC
Set forecasted price equal to estimated marginal cost & solve for Q*
P = a + 2bQ* + 3cQ*2

37. Implementing the Profit-Maximizing Output Decision
Step 5: Compute profit or loss
Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
If P < AVCmin, firm shuts down & profit is -TFC

38. Profit & Loss at Beau Apparel (Figure 11.13)

39. Profit & Loss at Beau Apparel (Figure 11.13)

40. Summary
Perfect competitors are price-takers, produce homogenous output, and have no barriers to entry
The demand curve for a perfectly competitive firm is perfectly elastic (or horizontal) at the market determined equilibrium price, and marginal revenue equals price
Managers make two decisions in the short run: (1) produce or shut down, and (2) if produce, how much to produce
When positive profit is possible, profit is maximized at the output where P = SMC
When market price falls below minimum AVC the firm shuts down and produces nothing, losing only TFC

41. Summary
In long-run competitive equilibrium, all firms are in profit-maximizing equilibrium (P = LMC)
No incentive for firms to enter or exit the industry because economic profit is zero (P = LAC)
Choosing either output or input usage leads to the same optimal output decision and profit level
Five steps to find the profit-maximizing rate of production and the level of profit for a competitive firm:
Forecast the price of the product
Estimate average variable cost and marginal cost
Check the shutdown rule
If P ≥ min AVC find the output level where P = SMC
Compute profit or loss