Download Chapter 7: THE COMPETITIVE FIRM The Competitive Firm The

Chapter 7:
THE COMPETITIVE FIRM
What are profits?
What are the unique characteristics of
competitive firms?
How much output will a competitive firm
produce?
The Competitive Firm
The Profit Motive
✸ Economic vs. Accounting Profits
✸ The Nature of Competition
✸ The Production Decision
✸ Profit-Maximizing Rule
✸ The Shutdown Decision
✸ The Investment Decision
✸ Determinants of Supply
✸
The Competitive Firm
Page 2
The Profit Motive
✸
Assumption
» Goal of all firms is to maximize profits
✸
Other Motivations
» Pride in product
» Control
» Freedom
» Flexibility
The Competitive Firm
Page 3
Economic vs. Accounting Costs
✸
Accounting Costs
» Explicit costs which incur cash outlay
» Wages, rent, utilities, cost of materials
✸
Economic Costs
» Explicit cost plus Implicit costs
» Implicit costs are opportunity costs of
owner supplied resources
–
–
Forgone earnings (time)
Forgone return (money)
The Competitive Firm
Page 4
Economic vs. Accounting Profits
✸
Accounting Profits
» Total revenue minus accounting costs
✸
Economic Profits
» Total revenue minus economic costs
✸
Normal Profit
» Profit equal to implicit costs
The Competitive Firm
Page 5
Accounting vs. Economic Profits
Economics Profits
Accounting Profits
Monthly Income Statement
(using Accounting Costs)
Revenue
$50,000
Costs
COGS
$30,000
Wages
10,000
Rent
2,000
Utilities
1,000
Total Costs
$43,000
Total Profit
$7,000
Monthly Income Statement
(using Economic Costs)
Revenue
$50,000
Costs
COGS
$30,000
Wages
10,000
Rent
2,000
Utilities
1,000
Explicit Costs
$43,000
Forgone Salary
3,000
Forgone Return
100
Implict Costs
$3,100
Total Profit
$3,900
Assume forgo salary =$36,000/yr
Forgo $10,000 @ 12% return
The Competitive Firm
Page 6
Types of Markets
Type of
Market
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Number
of
Barriers
Example Firms to Entry
Wheat,
Many
None
Corn
Type of
Product
Standardized
(identical)
Control Over
Price
None
Fast
Food,
Clothing
Cars,
Steel
Many
Low
Differentiated
Some
Few
High
Either type
Considerable
Electric,
Water
One
High
Unique
Considerable
The Competitive Firm
Page 7
The Nature of Competition
✸
Characteristics of Perfect Competition
» Large number of small sellers
–
Small market shares
» Homogenous product (identical)
» No barriers to entry
» Perfect information about prices
» Price Takers
–
–
No control over price
Quantity adjusters
The Competitive Firm
Page 8
The Nature of Competition
✸
Market Demand Curves
» Downward sloping (law of demand)
✸
Firm Demand Curves
» Price takers have flat, horizontal
demand curves
» If a seller increases price above market
price, sales would drop to zero
The Competitive Firm
Page 9
Market & Firm Demand Curves
Price
Price
Supply
E
PE
$25
P$25
Firm’s
Demand
Curve
QE
Market
Demand
Quantity( thousands
jeans per day)
Quantity
(jeans per day)
The Competitive Firm
Page 10
The Production Decision
✸
Output and Revenues
» Total Revenue = Price x Quantity
» As output increases, TR increases
✸
Output and Costs
» As output increases, TC increases
✸
Total Profit
» Difference between TR and TC
The Competitive Firm
Page 11
The Production Decision
Total Cost
Dollars
Losses
Total Revenue
Profits
Losses
0
The Competitive Firm
Quantity
Page 12
Profit-Maximizing Rule
✸
Marginal Analysis
» Compare the extra benefit of selling one
more unit with the extra cost
✸
Marginal Revenue (MR)
» Extra revenue generated from selling an
additional unit of output
✸
Marginal Cost
» Extra cost of producing one more unit
The Competitive Firm
Page 13
Profit-Maximizing Rule
✸
Profit-Maximizing Rate of Output
» If MR > MC, produce output
» If MR < MC, don’t produce output
» If MR = MC, profit maximizing output
✸
MR = Price
» For a perfectly competitive firm, extra
revenue generated from one more unit
sold is the price of the good
The Competitive Firm
Page 14
Profit-Maximizing Rule
MC & MR
$ per jeans
MC
Profit
maximizing
point
35
Loss from
10th jeans
P = MR
25
20
Profit from
8th jean
For 8th jean
MR = $25
MC = $20
For 10th jean
MR = $25
MC = $35
Mπ = $5
Mπ = ($15)loss
0
8 9 10
Quantity (jeans per day)
The Competitive Firm
Page 15
Adding Up Profits
✸
Profit Maximization Rule
» Pick Q* where Price = MC
» Necessary condition for profit max
» But not a guarantee for profit > 0
π = TR - TC
= P(Q) - ATC(Q)
= (P - ATC)Q
» Compare price with ATC
The Competitive Firm
Page 16
Adding Up Profits
✸
Total Profit, (π)
» If P > ATC, π > 0
» If P < ATC, π < 0
» If P = ATC, π = 0
–
Breakeven point, at min of ATC
π = TR - TC
= P(Q) - ATC(Q)
= (P - ATC)Q
The Competitive Firm
Page 17
Short-run Profit Maximization
Cost schedule
Q = jeans/day
Q
TC
0
30
1
2
Assume Market price = $32
Find profit maximizing quantity
MC
ATC
AVC
40
48
10
8
40
24
10
9
3
57
9
19
9
o Find cost per unit at Q*
4
5
68
85
11
17
17
17
9.5
11
ATC* = $20/jean
6
108
23
18
13
7
140
32
20
15.71
8
180
40
22.5
18.75
The Competitive Firm
n Pick Q* where MR = MC
Pick Q* where $32 = $32
Q* = 7 jeans/day
p Find profit
π = (P - ATC) Q
= ($32 - $20) 7
= ($12)7 = $84/day
Page 18
Price & cost
Dollars/unit
Short-run Profit Maximization
p Profit = ($32-$20)7 =$84/day
40
35
30
25
20
15
10
5
0
MC
n
P = MR
o
0
1
2
3
4
5
6
The Competitive Firm
ATC
AVC
7
8
Quantity
Jeans/day
Page 19
Price & cost
Dollars/unit
Short-run Profit Maximization
40
35
30
25
20
15
10
5
0
MC
Loss = ($11-$17)4 =$24/day
ATC
AVC
P = MR
0
1
2
3
4
5
The Competitive Firm
6
7
8
Quantity
Jeans/day
Page 20
The Shutdown Decision
✸
Shutdown Decision
» If profit < 0, (i.e. P < ATC)
–
✸
Continue to operate at a loss or Shutdown?
Loss Minimization
» Don’t consider fixed costs
–
You must pay in either case (sunk costs)
» Only consider variable cost
The Competitive Firm
Page 21
The Shutdown Decision
You run a package delivery service
Your only delivery for the month is to Miami
✸
✸
✸
✸
✸
Recieve offer for $200
Should you take trip ?
If you take the trip then
Profit = TR - TC
= $200 - $230 = -$30
Lose $30 for the month
If you don’t take trip still
have to pay fixed cost
Lose $150 for the month
As long as revenue covers
variable costs , then operate
Cost Schedule
Variable costs
Wages
$50
Gas
20
Tolls
10
Total variable costs
$80
Fixed costs
Truck payment $100
Insurance
50
Total Fixed costs
$150
Total Cost
$230
The Competitive Firm
Page 22
The Shutdown Decision
✸
Price vs AVC
» If Price > AVC, operate at a loss
» If Price < AVC, shutdown
» If Price = AVC, shutdown point
–
At the minimum of the AVC curve
The Competitive Firm
Page 23
Price & cost
Dollars/unit
Break-even & shutdown points
40
35
30
25
20
15
10
5
0
MC
ATC
AVC
BE
SD
0
The Competitive Firm
1
2
3
4
5
6
7
8
Quantity
Jeans/day
Page 24
Determinants of Supply
✸
Firm’s Supply Curve
» Relationship between price and QS
» Marginal cost curve above minAVC
✸
Short-Run Determinants
» Price of inputs, technology, etc.
✸
Supply Shifts
» Anything that affect MC, will shift curve
The Competitive Firm
Page 25
The Investment Decision
✸
Investment Decision
» Decision to expand or contract plant size
» Decision to enter or exit an industry
✸
Long-Run Costs
» Planning horizon
» Pick plant size best suited for expected
rate of output
The Competitive Firm
Page 26