Chapter 11: Managerial Decisions

in Competitive Markets

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 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

11-2
 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

11-3
 Demand for a Competitive
Price-Taking Firm (Figure 11.2)

P0 P0
D=
MR

) sr all od( eci r P

) sr all od( eci r P

0 Q0 0

Quantity Quantity

Panel A – Panel B – Demand curve

Market facing a price-taker 11-4
 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
1. 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 11-5
 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

11-6
 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

π ( P − ATC )Q
Average profit = =
Q Q
= P − ATC = Profit margin
11-7
 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

11-8
 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

11-9
 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

11-10
Profit Maximization: P = $36
(Figure 11.3)

11-11
Profit Maximization: P = $36
(Figure 11.3)

11-12
 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

11-13
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)

Profit = $3,150 -
$5,100 =
-$1,950

Total revenue = $10.50 x

300 = $3,150

11-14
 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
11-15
 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

11-16
 Computing Short-Run
Producer Surplus (Figure 11.6)
Producer surplus = TR − TVC
= $9 × 110 − $5.55 × 110
= $990 − $610
= $380
Or, equivalently,
Producer surplus = Area of trapezoid edba in Figure 11.6
= Height × Average base
 80 + 110 
= ($9 − $5) ×  
 2 
= $380
$380 multiplied by 100 firms = ($380 × 100) = $38, 000 11-17
Short-Run Firm & Industry Supply
(Figure 11.6)

11-18
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)

Profit = ($17 - $12) x

240 = $1,200

11-19
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

11-20
Long-Run Competitive Equilibrium
(Figure 11.8)

11-21
 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

11-22
 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

11-23
 Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)

11-24
 Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)

Firm’s
output

11-25
 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
11-26
 Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)

11-27
Profit-Maximizing Input Usage
• Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit

11-28
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
11-29
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

11-30
 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
b
Qmin =−
2c
AVC min = a + bQmin + cQ 2
min
11-31
 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
11-32
Profit & Loss at Beau Apparel
(Figure 11.13)

11-33
Profit & Loss at Beau Apparel
(Figure 11.13)

11-34