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1 Managerial Economics • • • • • • • • • • • 1 In economics, market structure (also known as market form) describes the state of a market with respect to competition. The major market forms are: Perfect competition, in which the market consists of a very large number of firms producing a homogeneous product. Monopolistic competition, also called competitive market, where there are a large number of independent firms which have a very small proportion of the market share. Oligopoly, in which a market is dominated by a small number of firms which own more than 40% of the market share. Oligopsony, a market dominated by many sellers and a few buyers. Monopoly, where there is only one provider of a product or service. Natural monopoly, a monopoly in which economies of scale cause efficiency to increase continuously with the size of the firm. Monopsony, when there is only one buyer in a market. The imperfectly competitive structure is quite identical to the realistic market conditions where some monopolistic competitors, monopolists, oligopolists, and duopolists exist and dominate the market conditions. These somewhat abstract concerns tend to determine some but not all details of a specific concrete market system where buyers and sellers actually meet and commit to trade. 2 Managerial Economics Market Structure/Form Market Structure Seller Entry Barriers Seller Number Buyer Entry Barriers Buyer Number Perfect Competition No Many No Many Monopolistic competition No Many No Many Oligopoly Yes Few No Many Oligopsony No Many Yes Few Monopoly Yes One No Many Monopsony No Many Yes One 2 3 Managerial Economics Continued… 3 • The correct sequence of the market structure from most to least competitive is perfect competition, imperfect competition, oligopoly, and pure monopoly. • The main criteria by which one can distinguish between different market structures are: the number and size of producers and consumers in the market, the type of goods and services being traded, and the degree to which information can flow freely. 4 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 4 5 Managerial Economics 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 5 Managerial Economics 6 Demand for a Competitive Price-Taking Firm Price (dollars) Price (dollars) S P0 P0 D = MR D 0 Q0 Quantity Panel A – Market 6 0 Quantity Panel B – Demand curve facing a price-taker Managerial Economics 7 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 7 8 Managerial Economics 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 8 9 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 9 10 Managerial Economics Profit Maximization: P = $36 TotalProfit revenue =$36 x -600 = $21,600 $11,400 = $21,600 = $10,200 Total cost = $19 x 600 = $11,400 10 11 Managerial Economics Profit Maximization: P = $36 Panel A: Total revenue & total cost Panel B: Profit curve when P = $36 11 12 Managerial Economics Short-Run Loss Minimization: P = $10.50 Profitcost = $3,150 Total = $17 -x$5,100 300 = -$1,950 = $5,100 Total revenue = $10.50 x 300 = $3,150 12 13 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 13 14 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 • ( P ATC )Q 14 15 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 15 16 Managerial Economics Derivation of Short-Run Supply Curves 16 17 Managerial Economics Long-Run Profit-Maximizing Equilibrium Profit = ($17 - $12) x 240 = $1,200 17 18 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 18 19 Managerial Economics Long-Run Competitive Equilibrium 19 20 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 20 21 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 21 22 Managerial Economics Long-Run Industry Supply for a Constant Cost Industry 22 23 Managerial Economics Long-Run Industry Supply for an Increasing Cost Industry Firm’s output 23 24 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 24 25 Managerial Economics Economic Rent in Long-Run Competitive Equilibrium 25 26 Managerial Economics Profit-Maximizing Input Usage • Profit-maximizing level of input usage produces exactly that level of output that maximizes profit 26 27 Managerial Economics 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 27 28 Managerial Economics 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 28 29 Managerial Economics Profit-Maximizing Labor Usage 29 30 Managerial Economics Implementing the ProfitMaximizing Output Decision • Step 1: Forecast product price • Use statistical techniques • Step 2: Estimate AVC & SMC 30 • AVC a bQ cQ • SMC a 2bQ 3cQ 2 2 31 Managerial Economics 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 31 32 Managerial Economics 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 * 32 *2 33 Managerial Economics 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 33