Download A Firm in a Compeitive Market

The Competitive Firm
Chapter 7
In this Chapter..
7.1. Market Structure
7.2. Profit Maximization for A firm in
Perfectly Competitive Market
7.3. When to Shutdown; and the Supply
Curve of a Competitive firm
The Profit Motive


The basic incentive for producing goods
and services is the expectation of profit.
Profit is the difference between total
revenue and total cost.
Other Motivations

Personal reasons also motivate
producers.


Producers seek social status and crave
recognition.
Non-owner managers of corporations may
be more interested in their own jobs,
salaries, and self-preservation than earning
profits for stockholders.
Is the Profit Motive Bad?

The profit motive encourages businesses
to produce the goods and services
consumers’ desire, at prices they are
willing to pay.



What Proportion of the Sales Price, do you
think, goes to Sellers (Producers) as Profit?
The typical consumer believes that 35¢ of
every sales dollar goes to profits.
In reality, average profit per sales dollar is
closer to 5¢.
Economic and Accounting
Profits


Economic profit is the difference
between total revenues and total
economic costs.
Economic cost is the value of all
resources used to produce a good or
service – opportunity cost.
Economic
Total
Total economic
=
–
profit
revenue
cost
Economic and Accounting
Profits

To determine a firm’s economic profit,
all implicit factor costs must be
subtracted from observed accounting
profit.
Economic = Accounting - Implicit
profit
profit
costs
Economic and Accounting
Profits



Economic profits represent something over and
above normal profits.
Normal profit is the opportunity cost of capital
A productive activity reaps an economic profit
only if it earns more than its opportunity cost.
Economic Profits
Total (gross) revenues
$27,000
less explicit costs:
Cost of merchandise sold
Wages to cashier, stock, and delivery help
$17,000
2,500
Rent and utilities
800
Taxes
700
Total explicit costs
Accounting profit (revenue minus explicit costs)
$21,000
$ 6,000
less implicit costs
Wages of owner-manager, 300 hours @ $10 per hour
Return on inventory investment, 10% per year on $120,000
Total implicit costs
Economic profit (revenue minus all costs)
$ 3,000
1,000
$ 4,000
$ 2,000
Entrepreneurship


The inducement to take on the added
responsibilities of owning and operating a
business is the potential for profit.
The potential for profit is not a guarantee of
profit.
1.
2.
substantial risks are attached to starting and
operating a business.
The opportunity for profit may be limited by the
structure of the industry.
7.1. Market Structure
Market Structure


Market structure refers to the
number and relative size of firms in an
industry.
Two broad Categories
1. Perfectly Competitive
2. Imperfectly Competitive
Market Structure
I. Perfect
Competition
II. Imperfect competition
•Monopolistic
competition
•Oligopoly
•Duopoly
•Monopoly
I. The Nature of Perfect
Competition

Distinguishing characteristics:




Many firms – lots of firms are competing for
consumer purchases.
Identical products – the products of the
different firms are identical, or nearly so.
Low entry barriers – it’s relatively easy to
get into the business.
Perfect Information-Every body knows every
thing about the market
Market Structure

Perfect competition is a market in
which no buyer or seller has market
power.
Price Takers

A perfectly competitive firm has no
market power and thus has no ability to
alter the market price of the goods it
produces.

Market Power – The ability to alter the
market price of a good or service.
Price Takers

The output of a perfectly competitive firm is
so small relative to market supply that it has
no significant effect on the total quantity or
price in the market.

Pricing decision is thus beyond the control of
the firm

The firm has to decide on how much to
produce
Market Demand Curves
vs.
The Demand Curves Facing A
Firm
Market Demand Curves vs. The
Demand Curves Facing A Firm

It is important to distinguish between
the market demand curve and the
demand curve confronting a particular
firm.
Market Demand Curves vs.
Firm Demand Curves

The market demand curve for a product
is always downward-sloping.
Market Demand Curves vs.
Firm Demand Curves
PRICE (per shirt)
The T-shirt market
Market supply
pe
Equilibrium
price
Market demand
Quantity (thousand shirts per day)
Market Demand Curves vs.
Firm Demand Curves


The market demand curve for a product
is always downward-sloping.
However, the demand curve confronting
a perfectly competitive firm is horizontal
Market Demand Curves vs.
Firm Demand Curves
The T-shirt market
Demand facing one shop
PRICE (per shirt)
Market supply
pe
Equilibrium
price
pe
Demand facing
single firm
Market demand
Quantity (thousand shirts per day)
Quantity (shirts per day)
The Production Decision


Thus a competitive firm has only one
decision to make: how much to produce.
The production decision is the selection
of the short-run rate of output (with
existing plant and equipment).
Output and Revenues

In searching for the most desirable rate
of output, the distinction between total
revenue and total profit must be kept in
mind.

Total revenue - The price of the good
multiplied by the quantity sold in a given
time period.
Total revenue = price X quantity
Output and Revenues

Total Revenue:

PXQ

Total Revenue Curve


an upward-sloping straight line
The Slope of The TR Curve:

pe.
Total Revenue
(P)
$8
8
8
8
8
8
8
8
8
(Q)
1
2
3
4
5
6
7
8
9
Total
Revenue
$ 8
16
24
32
40
48
56
64
72
Total Revenue
Price Quantity
$96
88
80
72
64
56
48
40
32
24
16
8
0
Total revenue
pe= $8
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Output and Costs

To maximize profits a firm must
consider how increased production
will affect costs as well as revenues.

Producers are saddled with certain costs
in the short-run.

Short-run - The period in which the
quantity (and quality) of some inputs cannot
be changed.
Output and Costs
– Fixed costs - Costs of production that do not
change when the rate of output is altered,
e.g., the cost of basic plant and equipment.

Fixed costs are incurred even if no output is
produced.
-Variable costs - Costs of production that
change when the rate of output is altered,
e.g. labor and material costs.

Once a firm starts producing output, it incurs
variable costs as well.
Total Cost (dollars per time period)
Total Cost
Total cost
z
Total costs escalate due to the
law of diminishing returns
Fixed cost
Output (units per time period)
Output and Costs

The shape of the total cost curve
reflects increasing marginal costs and
the law of diminishing returns.

Marginal cost is the increase in total
costs associated with a one-unit increase in
production.
Output and Costs

Given these conditions, the producer’s
problem is to find that one particular
rate of output that maximizes profits.
Revenues Or Costs (dollars per period)
Total Profit
Total cost
r
s
f
h
g
Output (units per period)
Total revenue
Profit-Maximizing Rule



The best single rule for maximizing
short-run profits is …
To never produce a unit of output that
costs more than it brings in.
What does this means?
Profit-Maximizing Rule

The producer has to compare the
contribution of the additional unit of the
output to the total revenue with the
what it costs to produce that additional
unit.

The contribution to total revenue of an
additional unit of output is called marginal
revenue.
Profit-Maximizing Rule

Marginal revenue (MR) is the change
in total revenue that results from a oneunit increase in the quantity sold.
Marginal Change in total revenue
=
revenue
Change in output

In a perfectly competitive market, MR is
simply the price of the product; MR=P
Marginal Revenue = Price
Rate of
Output
0
1
2
3
4
5
Price
$13
13
13
13
13
13
Total
Revenue
$0
13
26
39
52
65
Marginal
Revenue
$13
13
13
13
13
Marginal Cost



We know that, for a firm in perfectly
competitive market, the price of its product is
its marginal revenue.
The firm’s goal is not to maximize revenues,
but to maximize profits….To achieve this goal..
… the firm has to compare its Marginal Revenue
with its Marginal Costs and determine the best
level of output.
Marginal Cost

Recall:


Just as what an additional unit of output
brings in is the firms marginal revenue
(MR);
Marginal cost is what it costs the firm to
produce the additional unit of the output
Marginal Cost
Rate of
Output
0
1
2
3
4
5
Total Cost
Marginal
Cost
Average
Cost
$10
15
22
31
44
61
$ 5
7
9
13
17
$15.00
11.00
10.33
11.00
12.20
Profit-Maximizing Output



a firm should produce at that rate of output
where marginal revenue equals marginal cost.
Max Profit: MR=MC
As MR=P; the Profit maximizing Rate of
output is one that can be produced when
marginal cost equals the price of the product

P= MC
Profit-Maximizing Output



If marginal cost exceeds price, total profits
decline if the additional output is produced.
If marginal cost is less than price, total profits
increase if the additional output is produced.
Profits are maximized at the rate of output
where price equals marginal cost.
Short-Run Profit-Maximization
Rules for Competitive Firm
Price > MC  increase output
Price = MC  maintain output
and
maximize profit
Price < MC  decrease output
Profit-Maximizing Rate of
Output
$18
Marginal cost
Price or Cost (per bushel)
16
14
12
10
p = MC
MRB
Profits decreasing
Price (= MR)
Profits increasing
8
Profit-maximizing
rate of output
6
4
MCB
2
0
1
2
3
4
5
Quantity (bushels per day)
6
7
Adding Up Profits
Profits can be computed in two ways.
1. As a difference between total revenue
and total cost.

Total profit = total revenue – total cost
Adding Up Profits
2. As a difference between Price and
average total cost times the number
sold.
Profit per unit = price – ATC
Total profit = (p – ATC) X q
Alternative Views of Total
Profit
Price and average cost
Revenue or Cost (dollars per day)
$90
80
70
60
50
40
30
20
10
0
Total revenue
Maximum
total profit
Total cost
1
2 3 4 5
Rate of Output
6
7
Price or Cost (per unit)
Total revenue and total cost
$18
16
14
12
10
8
6
4
2
0
Average total
cost
Total Profit
Marginal cost
1
Price
Profit per
unit
Cost per unit
2 3 4 5
Rate of Output
6
7
Implication…


The profit-maximizing producer has no
desire to produce at that rate of output
where ATC is at a minimum.
I.e., profit max output is not necessarily at
the point where ATC is the lowest.
The Shutdown Decision

In a competitive market, the short-run profit
maximization rule does not guarantee any
profits.



It tells the output level that maximizes economic
profit.
A firm in such a market thus always want to produce
that level of output.
However, a competitive market is characterized by
free entry (lack of barriers to entry).
The Shutdown Decision

Economic profits being made by firms already in the
market will attract new (more) firms into that business.

Entry of new firms into the market will affect the market
supply and thus market price of the good.

As a result, it possible that a firm already in the market
could face and economic loss.

When should it shutdown the business?
The Shutdown Decision

A firm should shut down only if the
losses from continuing production
exceed fixed costs.

It is possible to run a business while
incurring losses, as long as the loss doesn’t
exceed the fixed cost
The Shutdown Point


However, when price does not cover
average variable costs at any rate of
output, production should cease.
The shutdown point is that rate of
output where price equals minimum
AVC.
Open 24 Hours, 7 days a week


When price exceeds average variable cost but
not average total cost, the profit maximizing
rule minimizes losses.
Think of the Opening and Closing hours of
businesses!



Some business shutdown after 10Pm other stay
open 24 hours.
If MR from sales during later hours pays for the
variable cost of staying open…stay open
Other wise shutdown
The Shutdown Point
Profit
Price or Cost
18
16
14
Loss
MC
ATC
X
12
10
Price
(=MR
)
AVC
Shutdown
MC
ATC
AVC
Price
Y
8
6
4
MC
ATC
AVC
Price
shutdown point
2
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity
Quantity
Quantity
The Firm’s Supply Curve

In the short run, the firms supply curve
is the portion of its MC curve which lies
to the right of the shutdown point.

The portion of it marginal cost curve that
lies to the right of the point where
P=MR=AVC
Price (per bushel)
Short-Run Supply Curve
$18
16
14
12
10
8
6
4
2
0
X
Shutdown
point
Y
Marginal cost
curve
1
2
3
=
Short-run supply curve
for competitive firm
4
5
Quantity Supplied (bushels per day)
Why is Supply curve upward slopping?
6
7
Short-Run Supply Curve

The marginal cost curve is the short-run
supply curve for a competitive firm.

Supply curve – A curve describing the
quantities of a good a producer is willing
and able to sell (produce) at alternative
prices in a given time period, ceteris
paribus.
Determinants of Supply

The quantity of a good supplied is
affected by all forces that alter marginal
cost. These include:




The price of factor inputs.
Technology (the available production
function).
Expectations (for costs, sales, technology).
Taxes and subsidies.
Supply Shifts


If any determinant of supply changes,
the supply curve shifts.
E.g. Tax Effects:



Property Taxes
Payroll Taxes
Profit Taxes
Property Taxes



Property taxes are a fixed cost.
They raise average costs and reduce
profit.
However, they don’t affect marginal
costs. Thus they leave the profitmaximizing output unchanged.
Payroll Taxes



Payroll taxes increase marginal costs.
They reduce the profit maximizing rate of
output.
Thus they increase not only the average costs
but also lower the total and per-unit profits.
Thus altering the profit maximizing output
level
Profit Taxes



Profit taxes are neither a fixed cost nor a
variable cost.
They don’t affect marginal cost or prices.
They don’t affect production level decisions
but may affect investment decisions.
Impact of Taxes on Business
Decisions
Property taxes
affect fixed costs
MC1
ATCa
ATC1
pe
Payroll taxes
alter marginal
costs
Profits taxes
don't change
costs
MCb
MC1
MC1
ATCb
ATC1
pe
q1
ATC1
pe
qb q1
q1