Managerial Economics

eighth edition

Thomas Maurice

Chapter 11

Managerial Decisions in Competitive Markets

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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

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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
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Demand for a Competitive Price-Taking Firm (Figure 11.2)

S

Price (dollars)

Price (dollars)

P0

P0

D = MR

D 0 Q0 0

Quantity

Quantity

Panel A Market
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Panel B Demand curve facing a price-taker

Managerial Economics

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 = TR TC
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Profit Margin (or Average Profit)

( P ATC )Q Average profit Q Q

P ATC Profit margin

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

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Short-Run Output Decision

Firms manager will produce output where P = MC as long as:
TR TVC
or, equivalently, P AVC

If price is less than average variable cost (P AVC), manager will shut down
Produce zero output Lose only total fixed costs Shutdown price is minimum AVC
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Profit Maximization: P = $36

(Figure 11.3)

Total revenue =$36 x -600 Profit = $21,600 $11,400 = $21,600 = $10,200

Total cost = $19 x 600 = $11,400

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Profit Maximization: P = $36

(Figure 11.4)

Panel A: Total revenue & total cost

Panel B: Profit curve when P = $36

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Short-Run Loss Minimization: P = $10.50 (Figure 11.5)

Profit = $3,150 x 300 Total cost = $17 - $5,100 = -$1,950 = $5,100

Total revenue = $10.50 x 300 = $3,150

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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

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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 ( P ATC )Q

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Short-Run Supply Curves

For an individual price-taking firm
Portion of firms 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
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Derivation of Short-Run Supply Curves (Figure 11.6)

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Long-Run Profit-Maximizing Equilibrium (Figure 11.7)

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

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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

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Long-Run Competitive Equilibrium (Figure 11.8)

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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
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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)
As industry output expands, input prices rise, & minimum LAC rises Long-run supply price rises & curve is upward sloping

Increasing cost industry

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

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Long-Run Industry Supply for an Increasing Cost Industry (Figure 11.10)

Firms output

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Economic Rent
Payment to the owner of a scarce, superior resource in excess of the resources opportunity cost In long-run competitive equilibrium firms that employ such resources earn only normal profit
Economic profit is zero Potential economic profit is paid to the resource as rent
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Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11)

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Profit-Maximizing Input Usage

Profit-maximizing level of input usage produces exactly that level of output that maximizes profit

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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

TR MRP P MP L

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
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Profit-Maximizing Input Usage

Average revenue product (ARP)
Average revenue per worker
TR ARP P AP L

Shut down in short run if ARP < MRP When ARP < MRP, TR < TVC
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Profit-Maximizing Labor Usage

(Figure 11.12)

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Implementing the ProfitMaximizing Output Decision

Step 1: Forecast product price
Use statistical techniques from Chapter 7

Step 2: Estimate AVC & SMC 2 AVC a bQ cQ

SMC a 2bQ 3cQ 2

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Implementing the ProfitMaximizing Output Decision

Step 3: Check shutdown rule
If P AVCmin, produce If P < AVCmin, shut down To find AVCmin, substitute Qmin into AVC equation

Qmin

b 2c

2 AVC min a bQmin cQmin

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Implementing the ProfitMaximizing 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

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Implementing the ProfitMaximizing Output Decision

Step 5: Compute profit or loss Profit = TR - TC
P Q AVC Q TFC
* *

( P AVC )Q TFC
*

If P < AVCmin, firm shuts down & profit is -TFC

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Profit & Loss at Beau Apparel

(Figure 11.13)

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Profit & Loss at Beau Apparel

(Figure 11.13)

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