Lecture 16: Profit Maximization and Long-Run Competition
Session ID: DDEE
EC101 DD & EE / Manove Profits and Long Run Competition p 1
EC101 DD & EE / Manove Clicker Question p 2 Cost, Revenue and Profits Total Cost (TC): TC = FC + VC Average Cost (AC): AC = TC / Q Sometimes called Average Total Cost (ATC) Profits: = Total Revenue − Total Cost = (P x Q) − TC = (P x Q) − AC x Q = (P − AC) Q Producer surplus is the same as profits before fixed costs are deducted. =(P x Q) − VC − FC =PS− FC
EC101 DD & EE / Manove Producer Costs>Cost Concepts p 3
A Small Firm in a Competitive Market The equilibrium price P* is determined by the entire market. If all of the other firms charge P* and produce total output Q0, then … Market Last Small Firm P S P
D P* P*
Q* = Q0 + QF D Q Q Q Q0 0 QF for the last small firm, the remaining demand near the market price seems very large and very elastic. The last firm’s supply determines its own equilibrium quantity: it will also charge the market price (and be a price-taker).
EC101 DD & EE / Manove Perfect Competition>Small Firm p 4 Supply Shifts in a Competitive Market Suppose Farmer Jones discovers that hip-hop music increases his hens’ output of eggs. Then his supply curve would shift to the right.
But his price wouldn’t change.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Supply Shift p 5
How does the shift of his supply curve affect Farmer Jones? P P S S S’
P* D
D Q Q Market Farmer Jones Farmer Jones’ supply shifts to the right, but his equilibrium price remains the same. Doesn’t the market supply shift? No. Why not? Would Farmer Jones sell more or less? EC101 DD & EE / Manove Perfect Competition>Small Firm>Supply Shift p 6 NOW suppose that all farmers find out that hip-hop music increases their hens’ output of eggs.
All the farmers blast hip-hop at their chickens.
And the chicken’s start laying eggs like crazy.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Supply Shift p 7
Egg Market Farmer Jones P S S’ P S S’
P* D P’ D’ D Q Q Hip-hop causes the supply curves of Farmer Jones and the other farmers to shift to the right,… …which causes market supply to shift. The new market-equilibrium price would fall to P’, so Farmer Jones’ demand shifts down. Farmer Jones’ supply has shifted to the right, but he must sell at a lower price. Would he sell more? or less? EC101 DD & EE / Manove Perfect Competition>Small Firm>Supply Shift p 8 EC101 DD & EE / Manove Clicker Question p 9
Marginal and Average Costs MC is the cost of producing a given unit. 160 AC is the average cost of 140 MC producing all the units up to 120 the given unit. 100 80 AC MC rises eventually – Why? 60 If FC > 0, AC starts high,… 40 but it falls as fixed cost is 20 divided over more output,… 0 Q 012345678910 and rises again as MC becomes more important. If MC crosses AC, it must cross at the bottom of the AC curve. If MC is under AC, then MC is pulling the average down. But if MC is above AC, then MC is pulling the average up. EC101 DD & EE / Manove Perfect Competition>Small Firm>MC & AC p 10 Using AC to Measure Profits 160 If P = 120 then, if the firm MC produces, profits are 140 120 Total Profits maximized when the firm 100 produces 8 units. Why? 80 AC 60 If 8 units are produced, 40 AC = 90,… 20 0 Q so average profits per 012345678910 unit are 30. Total profits are 8x30=240.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Profits p 11
Using AC to Measure Losses
If P = 70 then, if the firm 160 produces, profits are 140 MC maximized when the firm 120 produces 4 units. Why? 100 If 4 units are produced, 80 Losses AC AC = 80,… 60 40 so on average the firm 20 loses 10 per unit (even 0 Q though profits are 012345678910 maximized). Total losses are 4x10=40. The firm cannot be profitable at this price, and it should shut down.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Losses p 12 The Shut-Down Condition If a firm is producing at the profit-maximizing level of output, yet still cannot earn a positive profit,… then it should be shut down. This happens when price is less than the lowest possible average cost. Why? So, if P < min AC, the firm should stop producing.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Shut Down p 13
But in the short run, fixed costs that are already paid should not be treated as a costs in making the shut-down decision. Why not? Because they are sunk costs (not avoidable). So maybe the firm can stay open for a while. Often, in the short run, only variable costs are avoidable, so we should use AVC (average variable cost) as the value of AC. In the long run, all costs are avoidable, so we should use ATC (average total cost) as the value of AC.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Shut Down>Short Run p 14 Marginal and Average Costs This firm should not $160 be in business if the 140 MC market price is below 120 _____.80 AC 100 Price P is above the P Profits 80 Losses minimum AC, so the P’ 60 firm can produce 40 profitably. 20 But if the firm 0 Q produces at a price 012345678910 P’ less than the minimum AC, it would have to produce at a loss.
EC101 DD & EE / Manove Perfect Competition>Small Firm>Shut Down>Short Run p 15
The Firm’s Long-Run Supply Curve Long-Run Supply Curve In the long run, AC is $160 the same as ATC. MC 140 Can you tell how much 120 SL the firm will want to sell SS 100 ATC if the price is S $120 per unit? 80 L $81? 60 AVC SS $60? 40 $40? 20 S 0 Q If P < min ATC, then 012345678910 net profits must be In the short run, AC is often the negative at any output same as AVC instead of ATC. level, and the firm will shut down. The short-run MC could be higher, but we ignore that possibility. See the supply curve. EC101 DD & EE / Manove Perfect Competition>Small Firm>Supply Curve p 16 EC101 DD & EE / Manove Clicker Question p 17
Do real-world firms maximize profits? In the competitive model, maximizing profits also maximizes social surplus. But firms have some of the same problems maximizing profits that consumers have maximizing utility. The maximization problem is very difficult. Firms may not know their own marginal costs. They may not be acquainted with all feasible production methods. The psychology of entrepreneurs may create problems. Entrepreneurs tend to be biased by optimism. Or they may suffer from hubris (overconfidence).
EC101 DD & EE / Manove Profit Maximization>Real World p 18 The owners of firms face problems that individuals do not. Controlling their employees How to get workers to work hard? How to get managers to pursue the interests of the owner (instead of their own)? Fear of risk Maximizing profits may be risky,… so managers may choose very safe bets that are less profitable . Very safe business ventures are often not in the social interest, because new technologies and economic growth require a reasonable amount of risk. Is profit maximization is a good approximation of what real firms do in a free market?
EC101 DD & EE / Manove Profit Maximization>Real World p 19
The Search for Profits In the competitive model, firms maximize profits. Moreover, a large number of (greedy) entrepreneurs are searching for profitable business opportunities.
If the market price of a good and its production costs can generate economic profits,… these entrepreneurs will start new firms and enter the industry.
But if the market price is too low, firms will face losses… and some will close down.
EC101 DD & EE / Manove Perfect Competition>Entry p 20 Entry and Exit in the Long Run When an entrepreneur considers starting a firm, she has no sunk costs. [Why not?] (Therefore, ATC should be used as AC.) So she enters only if long-run economic profits can be found. Firms will continue to enter as long as these profits are available. But as they enter, the market supply shifts out, the market price falls, and further entry becomes less profitable. EC101 DD & EE / Manove Perfect Competition>Entry p 21
Entry stops when new firms would no longer be able to obtain economic profits. At that point, the economic profits of existing firms are zero. To illustrate this process, we use a fictional example of the market for corn.
EC101 DD & EE / Manove Perfect Competition>Entry p 22 Economic Profit in the Corn Market
The Market S One Firm MC AC Economic profit S = $104
2.00 2.00 Price
1.20 D Price ($/bushel) Price ($/bushel)
S 65,000 130 Quantity Quantity
At P = $2.00, Q = 130 and AC = $1.20, which is greater than the minimum AC.
EC101 DD & EE / Manove Perfect Competition>Entry p 23
The Effect of Entry on Price and Economic Profit However, economic profits will attract new firms, and entry will reduce both prices and profits.
The Market S S’ One Firm MC AC Economic profit = $50.4
2.00 2.00
1.50 1.50 Price 1.08 D Price ($/bushel) Price ($/bushel)
65,000 95,000 120 130 Quantity Quantity
EC101 DD & EE / Manove Perfect Competition>Entry p 24 Equilibrium when Entry Stops MC The Market One Firm AC
S
Price
1.00 1.00 Price ($/bushel) Price ($/bushel) D
115,000 90 Quantity Quantity
Entry of firms continues until all firms earn zero long-run economic profits. At this point, there are more firms, and each firm is producing at lower cost. EC101 DD & EE / Manove Perfect Competition>Entry p 25
In the long run, AC is ATC and Price One Firm ATC ATC = AVC + FC/Q MC FC/Q is large when firms are small (low output), but AVC is small. Price
AVC is large when firms are 1.00 large, but FC/Q is small. AVC FC/Q At either extreme, ATC will be Q large. 90 Quantity If we start with a small number of firms, entry leads to a result between these two extremes and minimizes ATC = AVC + FC/Q… meaning that competition trades off the number of firms and the size of each firm in a perfectly efficient way. EC101 DD & EE / Manove Perfect Competition>Entry>Efficiency p 26 Economic Losses in the Corn Market A market price below the minimum AC will result in economic losses. MC The Market One Firm AC
Economic loss = $21,000/year
S
1.05 Price ($/bushel) Price ($/bushel) 0.75 0.75 D Price
60 70 90 Quantity (millions of Quantity (1000s of bushels/year) bushels/year)
EC101 DD & EE / Manove Perfect Competition>Exit p 27
Equilibrium when Exit Stops MC
The Market One Firm AC S Price Price
D Quantity Quantity In the presence of long-run losses, Again production will occur at firms will exit from the industry, and minimum AC. the market price will increase. Exit will stop when losses disappear, and economic profits reach zero.
EC101 DD & EE / Manove Perfect Competition>Exit p 28 Imperfect Competition In the long run, perfect competition balances the number and size of firms perfectly. But imperfect competition does not. Later in the course, we show that some kinds of imperfect competition yield too many small firms. But perfect competition cannot create the iPod.
EC101 DD & EE / Manove Imperfect Competition p 29
EC101 DD & EE / Manove Clicker Question p 30 End of File
EC101 DD & EE / Manove End of File p 31