ECNE 610 Managerial Economics MAY 2014 Chapter8 1

ECNE 610 Managerial Economics MAY 2014 Chapter-8 1 Dr. Mazharul Islam

2 8 The Pricing and 5 Output Decisions: Perfect Competition Dr. Mazharul Islam

3 Lesson Objectives Competition and market types Pricing and output decisions in perfect competition Implications for managerial decisions describe what happens in the long run Dr. Mazharul Islam

4 The four types of market structure § Petroleum Dr. Mazharul Islam

5 The characteristics of Perfect Competition Market large number of relatively small buyers and sellers homogeneous (identical) products very easy market entry and exit price taker (no market power) perfect knowledge about their competitors Perfectly mobile factors of production Dr. Mazharul Islam

6 Pricing and output decisions in perfect competition Basic business decision process: entering a market using the following questions: Should the firm produce? If yes, how much (what quantity) should the firm produce? if the firm produce such an amount, how much profit or loss will be realized? if a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that the firm will eventually earn a profit) or should the firm exit? Dr. Mazharul Islam

7 Pricing and output decisions in perfect competition The Decision Rule: Produce in the short-run if it can realize 1 - A profit (or) 2 - A loss less than its fixed costs Dr. Mazharul Islam

8 Pricing and output decisions in perfect competition Key assumptions of the perfectly competitive market: the firm is a price taker the firm makes the distinction between the short run and the long run the firm’s objective is to maximize its profit (or minimize loss) in the short run the firm includes its opportunity cost of operating in a particular market as part of its total cost of production Dr. Mazharul Islam

9 Pricing and output decisions in perfect competition Perfectly elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product no limit to the total revenue that the firm can gain in a perfectly competitive market Dr. Mazharul Islam

10 Pricing and output decisions in perfect competition SHORT RUN PROFIT MAXIMIZATION: Two Approaches. . . First: Total-Revenue -Total Cost Approach Second: Marginal-Revenue -Marginal Cost Approach Dr. Mazharul Islam

11 Pricing and output decisions in perfect competition Total-Revenue -Total Cost Approach compare the total revenue and total cost schedules and find the level of output that either maximizes the firm’s profits or minimizes its loss. Dr. Mazharul Islam

12 Revenue of a competitive firm Total revenue (TR) = (price x quantity sold) = PQ Average revenue Revenue of typical unit sold Marginal revenue = TR/Q = PQ/Q =P Change in TR from additional unit sold = ∆TR/∆Q =P Dr. Mazharul Islam

13 TOTAL REVENUE-TOTAL COST APPROACH Total Product Total Fixed Cost Total Variable Cost $ 100 e $ 0 0 h n? 90 t 100 1 e 2 se 100 tio 170 a z 100 u 3 240 i o y 4 xim 100 300 n a a 100 5 370 C t m 6 100 450 i f o 7 100 540 r p 100 8 650 100 9 780 10 930 Total Cost $ 100 190 270 340 400 470 550 640 750 880 1030 Price: $130 Total Revenue Profit $ 0 130 260 390 520 650 780 910 1040 1170 1300 - $100 - 60 - 10 + 50 + 120 + 180 + 230 + 270 + 290 + 270 Dr. Mazharul Islam

Total revenue and total cost 14 $1, 800 1, 700 1, 600 1, 500 1, 400 1, 300 1, 200 1, 100 1, 000 900 800 700 600 500 400 300 200 100 0 Break-Even Point (Normal Profit) Total Revenue Maximum Economic Profits $290 Total Cost Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Dr. Mazharul Islam

15 Marginal-Revenue -Marginal Cost Approach Produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit (ie. MR=MC) Note: for the perfectly competitive firm, the MR=MC rule may be restated as P=MC because P=MR in perfectly competitive market Dr. Mazharul Islam

16 MARGINAL REVENUE-MARGINAL COST APPROACH Average Price = Total Fixed Variable Total Marginal. Economic Cost Revenue. Profit/Loss Product Cost 0 1 2 3 4 5 6 7 8 9 10 The same profit maximizing result! $100. 00 $90. 00 $190. 00 90 50. 00 85. 00 135. 00 80 33. 33 80. 00 113. 33 70 25. 00 75. 00 100. 00 60 20. 00 74. 00 94. 00 70 16. 67 75. 00 91. 67 80 14. 29 77. 14 91. 43 90 12. 50 81. 25 93. 75 110 11. 11 86. 67 97. 78 130 10. 00 93. 00 103. 00 150 $ 130 130 130 - $100 - 60 - 10 + 50 + 120 + 180 + 230 + 270 + 290 + 270 Dr. Mazharul Islam

17 $200 Profit Maximization Position Cost and Revenue Economic Profit 150 $130. 00 MC D=MR=AR ATC AVC 100 $97. 78 50 0 1 2 3 4 5 6 7 8 9 10 Dr. Mazharul Islam

18 Loss Minimization Position $200 Cost and Revenue Economic Loss MC 150 ATC AVC 100 $91. 67 $81. 00 50 0 D=MR=AR 1 2 3 4 5 6 7 8 9 10

19 Contribution margin: the amount by which total revenue exceeds total variable cost CM = TR – TVC if CM > 0, the firm should continue to produce in the short run in order to offset some of the fixed cost Dr. Mazharul Islam

20 Shutdown point: the lowest price at which the firm would still produce. At the shutdown point, the price is equal to the minimum point on the AVC. If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs. Dr. Mazharul Islam

21 How about the long-run? In the long run, the price in the competitive market will settle at the point where firms earn a normal profit economic profit invites entry of new firms shifts the supply curve to the right puts downward pressure on price and reduces profits. economic loss causes exit of firms shifts the supply curve to the left puts upward pressure on price and increases profits. Dr. Mazharul Islam

22 LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM Price MC ATC MR P Price = MC = Minimum ATC (normal profit) Q Quantity Dr. Mazharul Islam

23 Observations in perfectly competitive markets: the earlier the firm enters a market, the better its chances of earning above-normal profit. as new firms enter the market, firms must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors. firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead. Dr. Mazharul Islam

24 Implications of perfect competition for decision making most important lesson is that it is extremely difficult to make money. must be as cost efficient as possible. it might pay for a firm to move into a market before others start to enter. Dr. Mazharul Islam

25 The firm’s decision to cease production Ceasing production Short-run = Shutdown Long-run = Exit Conditions TR<VC TR/Q < VC/Q P < AVC Conditions TR<TC TR/Q < TC/Q P < ATC Dr. Mazharul Islam

26 Case Study: Wheat European Union There are some large wheat farms in the EU, but they are very small in relation to the whole wheat-growing industry. An individual farm could increase its output many times over without have any noticeable effect on total supply of wheat in the EU. A single farm is not able to affect the price of wheat in the EU, since it cannot shift the industry supply curve. The farm has to sell at whatever the industry price is. In addition wheat is wheat, and so there is no way to tell one farm’s wheat from another.

27 Where the Perfect Competition model fails: Although firms are relatively free to enter or leave the wheat industry, there are significant costs in doing either and these may affect the decisions of firms. Although information is fairly open in the industry, it is unlikely that producers and consumers will have perfect knowledge. The wheat industry in the EU may be close to being a perfectly competitive market, but not a precise one.

BREAK-EVEN ANALYSIS A breakeven analysis is used to determine how much sales volume your business needs to start making a profit in short run. The breakeven analysis is especially useful when you're developing a pricing strategy, either as part of a marketing plan or a business plan.

USES OF BREAK EVEVN POINT An important tool in terms of short-term planning and decision making It looks at the relationship between costs, revenue, output levels and profit Helpful in deciding the minimum quantity of sales Helpful in the determination of tender price Helpful in examining effects upon organization’s profitability Helpful in deciding about the substitution of new plants Helpful in sales price and quantity Helpful in determining marginal cost

DECISION MAKING q. How many units must be sold to breakeven? q. How many units must be sold to achieve a target profit? q. Should a special order be accepted? q. How will profits be affected if we introduce a new product or service?

BREAK EVEN POINT: Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs). Break Even Point (IN UNIT)= Fixed Cost /(Selling Price per unit. Variable Unit Cost) Break Even Point (in SAR)= Fixed Cost /(Selling Price per unit. Variable Unit Cost)

For example Suppose that your fixed costs for producing 100, 000 product were SAR 30, 000 a year. Your variable costs are SAR 2. 20 materials, SAR 4. 00 labor, and SAR 0. 80 overhead, for a total of SAR 7. 00 per unit. If you choose a selling price of SAR 12. 00 for each product, then: 30, 000 divided by (12. 00 - 7. 00) equals 6000 units. This is the number of products that have to be sold at a selling price of SAR 12. 00 before your business will start to make a profit.

Target Profits What if a firm doesn’t just want to breakeven – it requires a target profit Contribution per unit will need to cover profit as well as fixed costs Required profit is treated as an addition to Fixed Costs

Example Using the following data, calculate the level of sales required to generate a profit of SAR 10, 000: Selling Price = SAR 35 Variable Cost = SAR 20 Fixed Costs = SAR 50, 000

Solution Contribution = SAR 35 – SAR 20 = SAR 15 Level of sales required to generate profit of SAR 10, 000: SAR 50, 000 + SAR 10, 000 SAR 15 = 4000 units

LIMITATIONS Break-even analysis is only a supply side (costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. It assumes that fixed costs (FC) are constant. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. It assumes that the quantity of goods produced is equal to the quantity of goods sold (i. e. , there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period. In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant.

37 Do you have any question? Dr. Mazharul Islam