Chapter 11-

Managerial Decisions
in Competitive
Markets
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
 Free entry
Demand and Marginal
Revenue

 Demand is perfectly elastic

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
Demand for a Competitive
Price-Taking Firm
Profit-Maximization in the Short
Run
 In the short run, managers must make two
decisions:
 Produce or shut down?
 If shut down, produce no output and hires no variable
inputs
 If shut down, firm loses amount equal to TFC
 If produce, what is the optimal output level?
 If firm does produce, then how much?
 Produce amount that maximizes economic profit

Profit = π = TR − TC
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

 Average Profit = π/Q = (P – ATC)*Q / Q

 = P – ATC = Profit Margin

 The manager should always produce where

 MR = MC
 For a perfectly competitive firm this also equals price
Profit Margin

 The greatest profit margin occurs at point N

 Total profit is not being maximized
Profit Maximization

 TR = 36*600
 TC = 19*600
 Total Profit =
17*600 = 10200
 At N TP
 = 20*400 = 8000
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
Short Run Loss
Short Run Loss (P = $10.50)
 Do we operate in the short run?
 TR = 10.50 * 300 = 3150
 TC = 17 * 300 = 5100
 Total Profit = -1950
 Is this better than shutting down?
 Average fixed costs at 300 units are (17-9 = 8)
 Since fixed costs are constant they are 8*300 or
$2400
 Shutting down means we lose $2400
 Operate in the short run.
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
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
 π = (P – ATC) * Q
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
 Supply prices give marginal costs of production
for every firm
Short Run Supply Curve
Short-Run Producer Surplus

 Short-run producer surplus is the amount by

which TR exceeds TVC
 The area above the short-run supply curve that is
below market price over the range of output
supplied
 Exceeds economic profit by the amount of TFC
Producer Surplus –
Graphically
Producer Surplus –
Mathematically (P = 9)
 Producer Surplus = TR – TVC
 = 9 * 110 – 5.55 * 110 = $4.45 * 110 = $380
 $5.55 is AVC and $9 is Price
 We also can calculate the area on the graph
 Area of eabd
 The rectangle is = (9-5)*(80) = 320
 The triangle is = .5*(4)*(110-80) = 60
 PS = $380
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
 LR Competitive Equilibrium

 Since economic profit = 5*240 = 1200

 With free entry firms will enter
Long Run Competitive
Equilibrium

 After firms enter, supply increases and prices

fall until P = MC = ATC = LAC
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
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
Long-Run Industry Supply for a
Constant Cost Industry

 Perfectly elastic supply

Long-Run Industry Supply for an
Increasing Cost Industry

 As supply increases, resource costs increase

causing LAC to increase
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 zero economic profit
 Potential economic profit is paid to the resource as
economic rent
 In increasing cost industries, all long-run producer surplus
is paid to resource suppliers as economic rent
Economic Rent in Long-Run
Competitive Equilibrium

 Economic rents are seen when one firm is able to

produce at lower costs (entrepreneur talent)
Profit-Maximizing Input Usage

 Profit-maximizing level of input usage

produces exactly that level of output that
maximizes profit
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
 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
∆TR
MRP = = P × MP
∆L
Profit-Maximizing Input Usage
 Average revenue product (ARP)
 Average revenue per worker
 Shut down in short run if ARP < MRP
 When ARP < MRP, TR < TVC

TR
ARP = = P × AP
L
Profit Maximizing Labor
Usage
 Max profit occurs
where MRP =
ARP