MANAGERIAL DECISIONS IN COMPETITIVE MARKETS
Essential Concepts
1. Perfect competition occurs when a market possesses the following three characteris¬tics:
i. Firms are price-takers because each firm produces only a very small portion of total market or industry output.
ii. All firms in the market produce a homogeneous or perfectly standardized product.
iii. Entry into and exit from the market is unrestricted.
2. The demand curve facing a competitive price-taking firm is horizontal or perfectly elastic at the price determined by the intersection of the market demand and supply curves. Since marginal revenue equals price for a competitive firm, the demand curve is also simultaneously the marginal revenue curve (i.e., D = MR). Price-taking firms can sell all they want at the market price. Each additional unit of sales adds to total revenue an amount equal to price.
Profit Maximization in the Short Run:
3. In the short run, the firm incurs fixed costs that are unavoidable – i.e., they must be paid even if output is zero—and variable costs that can be avoided if the firm chooses to shut down.
4. Shut down refers to the decision in the short run to produce zero output, which means the manager hires no variable inputs. The only costs incurred during shut down are the unavoidable fixed costs (quasi-fixed costs are avoidable).
5. A manager makes two decisions in the short run: (1) whether to produce or shut down, and (2) if the decision is to produce, how much to produce.
6. In making the decision to produce or shut down, the manager will consider only the (avoidable) variable costs and will ignore fixed costs.
7. Profit margin is the difference between price and average total cost, which is equal to average profit (or profit per unit), as long as every unit is sold for the same price:
8. The output level that maximizes profit margin is not the output level that maximizes profit. For this reason, managers should ignore profit margin or profit per unit when making their production decisions. See Figure 11.3 in the textbook for a numerical example that shows why it is a mistake to maximize profit margin.
9. Break-even points are the output levels – there are usually two of these points—where price equals average total cost, and thus profit equals zero at these points.
10. In the short run, the manager of a firm will choose to produce the output where P = SMC, rather than shut down, as long as total revenue is greater than or equal to the firm’s total avoidable cost or total variable cost ( ). Or, equivalently, a firm should produce as long as price is greater than or equal to average variable cost ( ). If total revenue cannot cover total avoidable cost, that is, if total revenue is less than total variable cost (or equivalently, P < AVC), the man¬ager will shut down and produce nothing, losing an amount equal to total fixed costs.
11. Fixed costs are irrelevant in the production decision because the level of fixed cost has no effect on either marginal cost or minimum average variable cost, and thus no effect on the optimal level of output.
12. Sunk costs are irrelevant in the production decision because such costs are forever unrecoverable, no matter what output decision is made, and so sunk costs cannot affect current or future decisions.
13. Average costs are also irrelevant for production decisions. Only marginal cost matters when finding the positive amount of output that maximizes profit. Technical note: AVC is not employed to find the optimal output, but rather to make sure the optimal output is not zero (i.e, whether to shut down or not).
14. Summary of the manager’s output decision in the short-run:
i. Average variable cost tells whether to produce; the firm ceases to produce—shuts down—if price falls below minimum AVC.
ii. Marginal cost tells how much to produce: if P minimum AVC, the firm pro¬duces the output at which P = SMC.
iii. Average total cost tells how much profit or loss is made if the firm decides to produce; profit equals the difference between P and ATC multiplied by the quantity produced and sold.
15. The short-run supply curve for an individual price-taking firm is the portion of the firm’s marginal cost curve above minimum average variable cost. For market prices less than minimum average variable cost, quantity supplied is zero.
16. The short-run supply curve for a competitive industry can be obtained by horizon¬tally summing the supply curves of all the individual firms in the industry. Short-run industry supply is always upward sloping, and supply prices along the industry supply curve give the marginal costs of production for every firm contributing to industry supply.
17. Short-run producer surplus is the amount by which total revenue exceeds total variable cost and equals the area above the short-run supply curve below market price over the range of output supplied. Short-run producer surplus exceeds economic profit by the amount of total fixed costs.
Profit Maximization in the Long Run:
18. In long-run competitive equilibrium, all firms are maximizing profit (P = LMC). Long-run competitive equilibrium occurs because of the entry of new firms into the industry or the exit of existing firms from the industry. The market adjusts so that P = LMC = LAC, which is at the minimum point on LAC.
19. The long-run industry supply curve can be either flat (perfectly elastic) or upward sloping depending upon whether the industry is a constant cost industry or an increasing cost industry, respectively.
a. For a constant cost industry, as industry output expands, input prices remain constant, and the minimum point on LAC is unchanged. Since long-run supply price equals minimum LAC, the long-run industry supply curve is perfectly elastic (horizontal).
b. For an increasing cost industry, as industry output expands, input prices are bid up, causing the minimum point on LAC to rise, and long-run supply price to rise. The long-run industry supply curve for an increasing cost industry is upward sloping.
20. For both constant-cost and increasing-cost industries, long-run industry supply curves give supply prices for various levels of industry output allowing the industry to reach long-run competitive equilibrium. Thus, economic profit for every firm in the industry is zero at all points on the long-run industry supply. Furthermore, long-run supply prices give both LACmin and LMC for all firms in the industry.
21. Economic rent is a payment to the owner of a scarce, superior resource in excess of the resource’s opportunity cost. Firms that employ such exceptionally productive resources earn only a normal profit (economic profit is zero) in long-run competitive equilibrium because the potential economic profit from employing a superior resource is paid to the resource as rent.
22. As noted above, firms that employ exceptionally productive, superior resources earn zero economic profit in long-run competitive equilibrium. In increasing industries, all long-run producer surplus is paid to resource suppliers as economic rent. And, of course, for constant-cost industries there is zero producer surplus (and zero rent) since industry supply is perfectly horizontal.
Profit-Maximizing Input Usage:
23. Choosing either output or input usage to maximize profit leads to the same maximum profit level. The profit-maximizing level of input usage produces exactly that level of output that maximizes profit.
a. The marginal revenue product (MRP) of an additional unit of a variable input is the additional revenue from hiring one more unit of the input. For the variable input labor:
When a manager chooses to produce rather than shut down (TR > TVC), the optimal level of input usage is found by following this rule: If the marginal revenue product of an additional unit of the input is greater (less) than the price of the input, then that unit should (not) be hired. If the usage of the variable input varies continuously, the manager should employ the amount of the input at which MRP = input price.
b. Average revenue product (ARP) is the average revenue per worker (ARP = TR/L). ARP can be calculated as the product of price times the average product of labor:
A manager should shut down operation in the short-run if there is no level of input usage for which ARP is greater than or equal to MRP. When ARP is less than MRP, total revenue is less than total variable cost, and the manager minimizes losses in the short run by shutting down.
Implementing the Profit-Maximizing Output Decision:
24. The following steps that use empirical estimates of price and costs can be employed to find the profit-maximizing rate of production and the level of profit a competitive firm will earn.
Step 1: Forecast the price of the product. Use the statistical tech¬niques presented in Chapter 7 to forecast the price of the product.
Step 2: Estimate average variable cost (AVC) and marginal cost (SMC). The cubic specification is the appropriate form for estimating a family of short-run cost curves:
and
Step 3: Check the shutdown rule. If P AVCmin, then the manager should produce. If P < AVCmin, then the manager should shut down (i.e., Q* = 0).
Step 4: If P , find the output level where P = SMC. The profit-maximizing output level occurs where P = SMC. To find the optimal level of output, set forecasted price equal to estimated marginal cost and solve for Q*:
Step 5: Compute profit or loss. Once a manager determines how much to produce, the calculation of total profit is a straightforward matter.
If , the firm shuts down, and profit is –TFC.
Answers to Applied Problems
1. The fact that the club closed implies that it incurred economic losses, i.e., implicit costs must have exceeded $100,000. Assuming that the opportunity cost of capital is the only omitted implicit cost, the owner must have alternative investment opportunities with an expected rate of return greater than 10%.
2. a. – c. Your spreadsheet when price is $190 per unit should look like:
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)
Q TC TFC TVC AFC AVC ATC SMC TR MR PROF AVGPROF PROFMARG
0 5000 5000 0 xx xx xx xx 0 xx -5000 xx xx
100 10000 5000 5000 50.00 50.00 100 50 19000 190 9000 90 90
200 19000 5000 14000 25.00 70.00 95 90 38000 190 19000 95 95
300 27000 5000 22000 16.66 73.33 90 80 57000 190 30000 100 100
400 38000 5000 33000 12.50 82.50 95 110 76000 190 38000 95 95
500 50000 5000 45000 10.00 90.00 100 120 95000 190 45000 90 90
600 66000 5000 61000 8.33 101.66 110 160 114000 190 48000 80 80
700 84000 5000 79000 7.14 112.85 120 180 133000 190 49000 70 70
800 104000 5000 99000 6.25 123.75 130 200 152000 190 48000 60 60
900 126000 5000 121000 5.55 134.44 140 220 171000 190 45000 50 50
1000 150000 5000 145000 5.00 145.00 150 240 190000 190 40000 40 40
d. 300 units minimizes ATC ($90) and maximizes profit margin ($100)
e. 700 units will maximize profit ($$49,000), which will also maximize the value of the firm. The shareholder/owners will not want to fire you.
f. Tripling TFC to $15,000 will have no effect on the profit-maximizing decision: Q* is still 700 units. Unfortunately, the profit associated with 700 units will fall by $10,000 to $39,000.
g. Your spreadsheet columns 9 – 13 will now look like:
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