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Managerial Economics
eighth edition
Thomas
Maurice
Chapter 11
Managerial Decisions in
Competitive Markets
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Managerial Economics
Perfect Competition
• Firms are price-takers
• Each produces only a very small portion
of total market or industry output
• All firms produce a homogeneous
product
• Entry into & exit from the market is
unrestricted
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Demand for a Competitive
Price-Taker
• 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
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Demand for a Competitive
Price-Taking Firm (Figure 11.2)
Price (dollars)
Price (dollars)
S
P0
P0
D = MR
D
0
Q0
Quantity
Panel A –
Market
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Quantity
Panel B – Demand curve
facing
a price-taker
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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 =   TR  TC
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Profit Margin (or Average Profit)

( P  ATC )Q
Average profit  
Q
Q
 P  ATC  Profit margin
• 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
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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
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Profit Maximization: P = $36
(Figure 11.3)
TotalProfit
revenue
=$36 x -600
= $21,600
$11,400
= $21,600
= $10,200
Total cost = $19 x 600
= $11,400
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Profit Maximization: P = $36
(Figure 11.4)
Panel A: Total revenue
& total cost
Panel B: Profit curve
when P = $36
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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
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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
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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
•   ( P  ATC )Q
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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
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Derivation of Short-Run Supply
Curves (Figure 11.6)
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Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)
Profit = ($17 - $12) x 240
= $1,200
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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
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Long-Run Competitive
Equilibrium (Figure 11.8)
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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
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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
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Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)
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Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)
Firm’s output
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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
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Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)
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Profit-Maximizing Input Usage
• Profit-maximizing level of input
usage produces exactly that level
of output that maximizes profit
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Profit-Maximizing Input Usage
• Marginal revenue product (MRP)
• MRP of an additional unit of a variable input is
the additional revenue from hiring one more unit
of the input
TR
MRP 
 P  MP
L
• If choose to produce:
• If the MRP of an additional unit of input is
greater than the price of input, that unit should
be hired
• Employ amount of input where MRP = input price
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Profit-Maximizing Input Usage
• Average revenue product (ARP)
• Average revenue per worker
TR
ARP 
 P  AP
L
• Shut down in short run if ARP < MRP
• When ARP < MRP, TR < TVC
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Profit-Maximizing Labor Usage
(Figure 11.12)
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Implementing the ProfitMaximizing Output Decision
• Step 1: Forecast product price
• Use statistical techniques from
Chapter 7
• Step 2: Estimate AVC & SMC
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•
AVC  a  bQ  cQ
•
SMC  a  2bQ  3cQ
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Implementing the ProfitMaximizing Output Decision
• Step 3: Check shutdown rule
• If P  AVCmin, produce
• If P < AVCmin, shut down
• To find AVCmin, substitute Qmin into
AVC equation
Qmin
b

2c
2
AVC min  a  bQmin  cQmin
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Implementing the ProfitMaximizing Output Decision
• Step 4: If P  AVCmin, find output
where P = SMC
• Set forecasted price equal to
estimated marginal cost & solve for Q*
P  a  2bQ  3cQ
*
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Implementing the ProfitMaximizing Output Decision
• Step 5: Compute profit or loss
• Profit = TR - TC
 P  Q*  AVC  Q*  TFC
 ( P  AVC )Q*  TFC
• If P < AVCmin, firm shuts down &
profit is -TFC
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Profit & Loss at Beau Apparel
(Figure 11.13)
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Profit & Loss at Beau Apparel
(Figure 11.13)
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