Econ Dept, UMR Presents
PerfectPerfect CompetitionCompetition----AA ModelModel ofof MarketsMarkets StarringStarring uTheThe PerfectlyPerfectly CompetitiveCompetitive FirmFirm uProfitProfit MaximizingMaximizing DecisionsDecisions
\InIn thethe ShortShort RunRun
\InIn thethe LongLong RunRun FeaturingFeaturing
uAn Overview of Market Structures uThe Assumptions of the Perfectly Competitive Model uThe Marginal Cost = Marginal Revenue Rule uMarginal Cost and Short Run Supply uSocial Surplus PartPart II:II: ProfitProfit MaximizationMaximization inin thethe ShortShort RunRun u First, we define some terms u Second, we explore the MR = MC rule u Third, we look at the v The Break-even point, and v The Shut down point Reminders...Reminders...
u Firms operate in perfectly competitive output and input markets u In perfectly competitive industries, prices are determined in the market and firms are price takers u The demand curve for the firm’s product is perceived to be perfectly elastic TotalTotal andand MarginalMarginal RevenueRevenue u Total revenue is the amount of revenue the firm takes in from the sale of its product. TR = price x quantity sold u Marginal revenue is the change in revenue to a firm when it changes output by one unit MR = )TR/)q MarginalMarginal RevenueRevenue u Marginal Revenue is the change in revenue from selling one more, or one less unit u If the firm gets price p* for every unit it sells, as it does in perfect competition, then p* is the marginal revenue at all quantities v MR = D in TR /D in Q u Horizontal Demand Curve means, v MR = P DemandDemand Curve,Curve, d,d, asas seenseen byby thethe priceprice takingtaking firmfirm $
p* dd
0 q/t FirmFirm''ss HorizontalHorizontal DemandDemand CurveCurve u At P > p*, Sales = 0 u At P < p*, Less Profits then if Sell at p* u p* found from Market Equilibrium Price ProfitProfit MaximizationMaximization
u We assume that the firm is profit maximizing u Profit = Total Revenue - Total Cost u Total Revenue is P x q u Profit maximization means cost of producing any output is minimized
v The input mix is such that MPi/Pi = MPj/Pj for all variable inputs i and j used v The cost curves drawn are the lowest possible Consider the following data for a firm q TFC TVC MC P=MR TR TC TR-TC 0 $55 $ 0 $-- $ 40 1 55 45 40 2 55 65 40 3 55 70 40 4 55 80 40 5 55 95 40 6 55 120 40 7 55 155 40 8 55 200 40 9 55 255 40 10 55 320 40 Can you fill in the missing columns? WhatWhat isis thethe firmfirm's's profitprofit maximizingmaximizing levellevel ofof output?output? q TFC TVC MC P=MR TR TC TR-TC 0 $55 $ 0 $-- $40 $-- $ 55 $ -55 1 55 45 45 40 40 100 -60 2 55 65 20 40 80 120 -40 3 55 70 5 40 120 125 - 5 4 55 80 10 40 160 135 25 5 55 95 15 40 200 150 30 6 55 120 25 40 240 175 65 7 55 155 35 40 280 210 70 8 55 200 45 40 320 255 65 9 55 255 55 40 360 310 50 10 55 320 65 40 400 375 25 ProfitProfit MaximizingMaximizing u Since the perfectly competitive firm cannot choose the price, the only choice left for the firm is to choose how much to produce. u The firm will choose the quantity where TR-TC is the largest, in other words - where the difference between the TR and TC curves is the biggest ProfitProfit MaximizedMaximized whenwhen TRTR andand TCTC areare furthestfurthest apartapart TR $ TC
280
210
55 q* = 7 q/t ProfitProfit MaximizingMaximizing u Note that the slope of the TR and TC curves are the same at this quantity u This means the the derivative of TR is the same as the derivative of TC at q* u There is a way we can find q* without calculus, though u We will need to graph the MR and MC curves ProfitProfit MaxMax withoutwithout CalculusCalculus $ MC
MR
q1 q2 q3 q4 q/t ProfitProfit MaximizingMaximizing u Consider the quantity q1 $ MC u At q1 MR>MC. This means that the MR additional revenue from selling one more is greater than the cost of making one more. q q q/t u This means the firm will q1 q2 3 4 make more profit by making one more, so they will u The same is true at q2 ProfitProfit MaximizingMaximizing u At q3, MR=MC. This means that $ MC the firm will get exactly as much MR money from selling one more as it cost them to make one more q q q q q/t u So the firm has no 1 2 3 4 interest in making one more ProfitProfit MaximizingMaximizing u And at q4, MR
$5 $5 P=MR
D
Q/t/t q/t/t ComparingComparing MarginalMarginal CostCost andand MarginalMarginal RevenueRevenue toto MaximizeMaximize ProfitProfit
Market Firm MC P P S
$5 $5 P=MR
D
Q/t q/t The firm maximizes profits by producing where MR = MC.
Market Firm P P MC S
$5 $5 P=MR
D q Q/t q/t Why is q=300 the profit-maximizing level of output for the firm? Firm P MC ATC
$5 P=MR
0 100 250 300 340 q/t What will be the firm’s profit level at the profit-maximizing level of output?
Firm MC P ATC
$5.00 P=MR $3.50
0 100 250 300 340 q/t The firm’s profit at q=300 is $1.50 per unit, or $450.
Firm MC P ATC
$5.00 P=MR $3.50
0 100 250 300 340 q/t FirmFirm’’ss SupplySupply CurveCurve u In other words, given a price, the firm looks to the MC curve and produces that quantity u This is a supply curve--the relationship between quantity supplied and price u The Perfectly Competitive firm’s MC curve is its Supply Curve v Later, we qualify this to say the MC curve above the AVC curve ProfitProfit u We can also determine exactly how much profit the firm is making. u We know profit = total revenue - total cost u Since ATC=TC/q, we know ATC x q = Total Cost u We also know that total revenue = price times quantity u So Profit=(pxq)-(ATCxq)=(p-ATC)xq, or graphically... ProfitProfit =(p=(p--ATC)ATC) xx qq p MC ATC p MR profit AVC ATC
q q/t LossLoss u Note that as long as p>ATC at q*, there will be a profit. u But it may be possible that no matter how much is produced, the firm will still lose money u In this case the q* is the quantity where the firm loses the least amount of money u For example... LossLoss p MC ATC AVC
ATC The area is the loss p* MR
q* q/t TheThe decisiondecision ofof whetherwhether toto staystay openopen u Just because a firm is losing money in the short run doesn’t mean it should close its doors. Often we hear of major firms like IBM posting a loss, but they stay open u When does a firm shut down? TheThe decisiondecision ofof whetherwhether toto staystay openopen u If P*
p1 as given p1 p1 u Notice the use of “q” for the firm’s D Firm q/t MarketQ/t output, and “Q” for the market ProfitProfit MaximizationMaximization inin thethe ShortShort RunRun u p1 is the firm’s P P S marginal p1 p1 revenue, MR MR
D Firm q/t MarketQ/t ProfitProfit MaximizationMaximization inin thethe ShortShort RunRun u MR is compared P P S with the MC p1 p1 firm’s MR Marginal Cost, MC D Firm q/t MarketQ/t ProfitProfit MaximizationMaximization inin thethe ShortShort RunRun u MR=MC locates the P P S ATC profit MC p1 p1 maximizing MR
output, q1 if u p1 $ATC D q 1 q/t Q/t ProfitProfit MaximizationMaximization inin thethe ShortShort RunRun u or, MR=MC locates the P ATC P S loss AVC MC p1 p1 minimizing MR
output, q1 , if u ATC # p1 # D q AVC 1 q/t Q/t ProfitProfit MaximizationMaximization inin thethe ShortShort RunRun u or, Shut ATC Down if P AVC MCP S P < AVC p1 p1 MR
D q 1 q/t Q/t ProfitProfit oror Loss?Loss?
P P S ATC MC AVC p1 p atc 1 1 MR
D
q 1 q/t Q/t u Profit! (p1 - atc1)*q1 = ProfitProfit oror Loss?Loss?
P ATC P S AVC MC atc1 p1 p1 MR
D
q 1 q/t Q/t u Loss! (atc1 - p1)*q1 = ShutShut DownDown oror Operate?Operate?
P ATC P S AVC MC atc1 MC p p1 1 avc1 MR
D
q 1 q/t Q/t u Operate!Operate! Your loss, (atc1 - p1)*q1= is less than loss by shutting down, FC u FC = (atc1 - avc1)*q1 = ShutShut DownDown oror Operate?Operate?
ATC P P AVC MC S atc1 avc 1 p p1 1 MR
D
q 1 q/t Q/t u Shut down! Your loss by shutting down, FC =
(atc1 - avc1)*q1 = is less than by operating at q1 (atc1 - p1)*q1 = The End
Go ahead to Part III: Long Run Profit Maximization