Managerial Economics eighth edition Thomas Maurice Chapter 11

Managerial Economics eighth edition Thomas Maurice Chapter 11 Managerial Decisions in Competitive Markets Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

2 Managerial Economics Perfect Competition • Firms are price-takers • Each produces only a very small amount of total market or industry output • All firms produce a homogeneous (identical) product • Entry into & exit from the market is unrestricted (can easily enter market) 2 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

3 Managerial Economics Demand for a Competitive -Taker Price • 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 3 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Managerial Economics 4 Demand for a Competitive -Taking Firm (Figure 11. 2) Price (dollars) S P 0 D = MR D 0 Quantity 4 Panel A – Market Mc. Graw-Hill/Irwin 0 Quantity Panel B – Demand curve facing a price-taker Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Managerial Economics 5 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 = 5 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

6 Managerial Economics 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 6 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

7 Managerial Economics Short-Run Output Decision • Firm’s 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 7 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

8 Managerial Economics Profit Maximization: P = $36 (Figure 11. 3) Total. Profit revenue =$36 x-600 = $21, 600 $11, 400 = $21, 600 = $10, 200 Total cost = $19 x 600 = $11, 400 8 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

9 Managerial Economics Profit Maximization: P = $36 (Figure 11. 4) Panel A: Total revenue & total cost Panel B: Profit curve when P = $36 9 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

10 Managerial Economics Short-Run Loss Minimization: P = $10. 50 (Figure 11. 5) Profitcost = $3, 150 Total = $17 -x$5, 100 300 = -$1, 950 = $5, 100 Total revenue = $10. 50 x 300 = $3, 150 10 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

11 Managerial Economics 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 11 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

12 Managerial Economics 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 • 12 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

13 Managerial Economics 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 13 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

14 14 Managerial Economics Derivation of Short-Run Supply Curves (Figure 11. 6) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

15 Managerial Economics Long-Run Profit-Maximizing Equilibrium (Figure 11. 7) Profit = ($17 - $12) x 240 = $1, 200 15 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

16 Managerial Economics 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 16 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

17 17 Managerial Economics Long-Run Competitive Equilibrium (Figure 11. 8) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

18 Managerial Economics 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 18 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

19 Managerial Economics 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 19 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

20 20 Managerial Economics Long-Run Industry Supply for a Constant Cost Industry (Figure 11. 9) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

21 Managerial Economics Long-Run Industry Supply for an Increasing Cost Industry (Figure 11. 10) Firm’s output 21 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

22 Managerial Economics 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 only normal profit • Economic profit is zero • Potential economic profit is paid to the resource as rent 22 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

23 23 Managerial Economics Economic Rent in Long-Run Competitive Equilibrium (Figure 11. 11) Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

24 Managerial Economics Implementing the Profit. Maximizing Output Decision • Step 1: Forecast product price • Use statistical techniques from Chapter 7 • Step 2: Estimate AVC & SMC • • 24 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

25 Managerial Economics Implementing the Profit. Maximizing Output Decision • Step 3: Check shutdown rule • If P AVCmin, produce • If P < AVCmin, shut down • To find AVCmin, substitute Qmin into AVC equation 25 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

26 Managerial Economics 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* 26 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

27 Managerial Economics Implementing the Profit. Maximizing Output Decision • Step 5: Compute profit or loss • Profit = TR - TC • If P < AVCmin, firm shuts down & profit is -TFC 27 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

28 Managerial Economics Profit & Loss at Beau Apparel (Figure 11. 13) 28 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

29 Managerial Economics Profit & Loss at Beau Apparel (Figure 11. 13) 29 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

30 Managerial Economics Homework • Read Chapter 11 pages 396 – 421 • Do Tech probs. 1, 2, 3, 4, 6, 7, 8, 9 • Do Applied problems: 1, 6, 7, 8 30 Mc. Graw-Hill/Irwin Copyright © 2005 by the Mc. Graw-Hill Companies, Inc. All rights reserved.