Transcript Chapter 14 examines the behavior of firms in competitive markets. Recall:

Chapter 14 examines the behavior of firms in
competitive markets.
Recall:
Competitive market: A market with many buyers and
sellers trading identical products so that each is a
“price taker”
The actions of any one buyer or seller have a negligible
influence on price . . .
. . . so each takes the market-determined
price as a “given.”
Price is not a choice variable for competitive firms.
To see why, consider the effects of a possible
“maverick” price change.
If one maverick seller were to . . .
increase price:
His/her demand would fall to zero. (Why buy at
a “high” price when lower prices available?)
decrease price:
Needless sacrifice of profit margin. (Can already
sell as much as desired at the marketdetermined price.)
Product design, marketing strategy, etc., are not choice
variables for competitive firms.
(These decisions are basically assumed away with
identical product assumption.)
The only decision for a competitive firm:
How much should it produce?
(Is all this realistic?
Remember: the value of a model is in its predictive
power.)
Let’s start with some hypothetical cost data for a typical firm.
Output
TC
(widgets/ ($/day)
day)
0
4
1
10
2
18
3
28
4
40
5
54
6
70
MC
($/
widget)
6
8
10
12
14
16
The main thing about these
numbers is that they exhibit
the customary features of
cost functions (chapter 13).
($/widget)
MC
ATC
(widgets/day)
Now let’s add the assumption that the price of widgets is 11 $/widget.
Output
TR
(widgets/ ($/day)
day)
0
0
1
11
2
22
3
33
4
44
5
55
6
66
MR
($/
widget)
11
11
11
11
11
11
At any output level, total revenue
is just price x the number of units
sold.
Marginal revenue: the change in
total revenue that arises from an
extra unit of sales.
For a price-taking firm,
MR = price.
(As we’ll see, this isn’t true
for all firms.)
Now let’s pull together the cost and revenue data in one table.
MR
Profit
TR
MC
Output
TC
($/ ($/day)
(widgets/ ($/day) ($/day) ($/
widget) widget)
day)
0
4
0
1
10
11
2
18
22
3
28
33
4
40
44
5
54
55
6
70
66
6
11
8
11
10
11
12
11
14
11
16
11
Add profit,
defined as
TR - TC.
-4
1
4
5
4
1
-4
Profit is
maximized
at 5 $/day
with output
of 3
widgets/day.
We need to be able to characterize the profit-maximizing
output level in terms of marginals.
Start with output = 0 widgets/day and consider increasing
to 1 widget/day.
For this 1 unit increment . . .
MR > MC
11 >
6
The first unit of output adds more
to revenue than to cost . . .
. . . so profit goes up (by 5 $/day).
Similar result for the second 1 unit increment (going from
1 widget/day to 2 widgets/day) . . .
. . . and for the third 1 unit increment (going
from 2 to 3 widgets/day).
Now suppose we’re currently operating at an output
level of 3 widgets/day.
Should we boost output to 4 widgets/day?
For this 1 unit increment . . .
MR <
MC
<
12
11
The fourth unit of output would
add more to cost than revenue . . .
. . . so profit would go down
(by 1 $/day).
Increasing output from 3 to 4 widgets/day is not
advisable.
Or you can look at it “the other way around”:
Start at 4 widgets/day. Should we cut back to 3?
MC ( = 12, the cost savings if output is reduced by
this one unit increment) . . .
. . . is greater than MR ( = 11, the revenue that
would be foregone).
So cutting back from 4 to 3 widgets/day is advisable.
(It increases profit by 1 $/day.)
Characterization of the profit-maximizing output level in
terms of marginals:
MR > MC means you can increase profit by increasing
output.
MR < MC means you can increase profit by decreasing
output.
To maximize profit, operate at the output level for which
MR = MC.
Profit maximization graphically:
Start with conventional
cost curves.
($/widget)
Suppose that price is
p $/widget.
MC
ATC
p
MR
At output Q1,
MR > MC so . . .
. . . increase output to
increase profit.
At output Q2,
MR < MC so . . .
Q1
Q* Q2
(widgets/day)
. . . decrease output
to increase profit.
Q* (where MR = MC) is the profit-maximizing output level.
Representing the dollar value of maximum profit:
($/widget)
Profit at Q* =
profit (in $/day)
TR(Q*) - TC(Q*)
MC
ATC
p
= p x Q* MR
Q* x ATC(Q*)
= Q* x [p - ATC(Q*)]
Q*
(widgets/day)
Geometrically, the area of a rectangle with one side of length
[p - ATC(Q*)] . . .
. . . and one side of length Q*.
Let’s make some changes to the hypothetical numbers.
MR
Profit
TR
MC
Output
TC
($/ ($/day)
(widgets/ ($/day) ($/day) ($/
widget) widget)
day)
0
4 10
1
10 16
2
18 24
3
28 34
4
40 46
5
54 60
6
70 76
0
11
22
33
44
55
66
-4 -10
6
11
8
11
10
11
12
11
14
11
16
11
1 -5
4 -2
5 -1
4 -2
1 -5
-4 -10
Here are the TC
and profit figures
from before.
Now increase
TC by 6 at each
output level.
Profit is still
maximized at
output = 3
widgets/day. . .
. . . but now max
profit is negative!
Should the firm
“go out of
business”?
We have to distinguish between a temporary shutdown
and a permanent exit from the industry.
Shutdown: a short-run decision to produce zero output
during a specific period because of current market
conditions.
Exit: a long-run decision to leave the market.
The two decisions differ because most firms cannot
avoid their fixed costs in the short-run . . .
. . . but can do so in the long-run.
In this case, we say that, in the short-run, fixed costs
are “sunk.”
sunk cost: a cost that has already been committed and
cannot be recovered.
If fixed costs cannot be avoided in the short-run, they
are irrelevant to short-run decision-making.
Firm should continue to produce output in the short-run
as long as TR > VC.
Shut-down (produce zero output) only if TR < VC.
Now back to our (revised) numerical example:
At the profit-maximizing output level of 3 widgets/day:
TR = 33 . . . and TC = 34 . . . so profit = -1.
But VC = 24.
(VC = TC - FC
= 34 - 10 = 24.)
TR > VC implies that it is preferable to produce
3 widgets/day than to shut down (produce 0).
(Notice that profit at an output of 0 is -10!)
So it can be rational for a firm to continue operation in
the short-run even though profit is negative.
But if negative profit persists as short-run becomes
long-run . . .
. . . then exit (permanent decision to leave market).
Recall: Profit = TR - TC . . .
. . . where TC includes opportunity cost of
owners’ labor, financial capital, etc.
Negative profit means owners’ investments could earn
higher return in next-best alternative uses.
Summary:
Short-run shutdown criterion:
Shut down if:
TR < VC
TR ÷ Q < VC ÷ Q
p < AVC
Long-run exit criterion:
Exit if:
TR < TC
TR ÷ Q < TC ÷ Q
p < ATC