19/01/2017. Profit maximization and competitive supply

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1 Perfectly Cometitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Outut in the Short Run The Cometitive Firm s Short-Run Suly Curve The Short-Run Market Suly Curve Choosing Outut in the Long Run The Industry s Long-Run Suly Curve Students should be able to : determine the outcome of a erfectly cometitive market; identify the factors affecting the suly in the short and in the long eriod in a erfect cometitive market. Pindyck and Rubinfeld, chater The three basic assumtions of a cometitive market: rice taking, roduct homogeneity, free entry and exit: no barriers. Price Taking. Because each individual firm sells a sufficiently small roortion of total market outut, its decisions have no imact on market rice. Price Taker. Firm that has no influence over market rice and thus takes the rice as given

2 Product Homogeneity. When the roducts of all of the firms in a market are erfectly substitutable with one another that is, when they are homogeneous no firm can raise the rice of its roduct above the rice of other firms without losing most or all of its business. Free entry (or exit). (or exit) an industry. No entry and exit barriers Condition under which there are no secial costs that make it difficult for a firm to enter Why a market is erfectly cometitive. Firm that has no influence over market rice and thus takes the rice as given. Because firms can imlicitly or exlicitly collude in setting rices, the resence of many firms is not sufficient for an industry to aroximate erfect cometition. Conversely, the resence of only a few firms in a market does not rule out cometitive behavior. 291 Profit. The rofit is the difference between the total revenue (TR) and total cost (TC): π = TR CT = CT() (1) In a erfectly cometitive market A cometitive firm sulies only a small ortion of the total outut of all the firms in an industry. Therefore, the firm takes the market rice of the roduct as given, choosing its outut on the assumtion that the rice will be unaffected by the outut choice. In (a) the demand curve facing the firm is erfectly elastic, even though the market demand curve in (b) is downward sloing

3 Profit for a firm in a erfectly cometitive market. Since each firm in a erfectly cometitive market is rice taker the relation (1) can be written as follow: The rofit maximization imlies: Where TR max π = TR TC = TC() (1) π π TR = = R is the marginal revenue and TC TC erfectly cometitive market the following relation holds: = c = 0 = c = c = MC is the marginal cost. For a firm in a R = TR = = = TR = AR Where AR is the average revenue. 293 Profit (continued): a grahical analysis. In the short run, the cometitive firm maximizes its rofit by choosing an outut * at which its marginal cost MC is eual to the rice (or marginal revenue MR) of its roduct. The rofit of the firm is measured by the rectangle ABCD. Any change in outut, whether lower at 1 or higher at 2, will lead to lower rofit. Why is the choice in A? In order to maximize the rofit the following holds: 2 π < c < 0 c >

4 Profit (continued): the short run rofit. A cometitive firm may roduce in the short run if rice is greater than average variable cost. But a cometitive firm should shut down if rice is below AVC. Shut-Down Rule: The firm should shut down if the rice of the roduct is less than the average variable cost of roduction at the rofit-maximizing outut (oint G). G P=AR 295 Examle 1: manager short run decision in an aluminum smelting lant. In the short run, the lant should roduce 600 tons er day if rice is above $1140 er ton but less than $1300 er ton. If rice is greater than $1300 er ton, it should run an overtime shift and roduce 900 tons er day. If rice dros below $1140 er ton, the firm should sto roducing, but it should robably stay in business because the rice may rise in the future

5 Examle 2: the short run roduction of etroleum roducts. Although lenty of crude oil is available, the amount that you refine deends on the caacity of the refinery and the cost of roduction. As the refinery shifts from one rocessing unit to another, the marginal cost of roducing etroleum roducts from crude oil increases sharly at several levels of outut. As a result, the outut level can be insensitive to some changes in rice but very sensitive to others. 297 Some cost consideration for managers To obtain useful measures of cost, managers should kee three guidelines in mind. 1. Excet under limited circumstances, average variable cost should not be used as a substitute for marginal cost. 2. A single item on a firm s accounting ledger may have two comonents, only one of which involves marginal cost. 3. Third, all oortunity costs should be included in determining marginal cost

6 From the rofit maximization to the suly curve in the short run The Short-Run Suly Curve for a Cometitive Firm In the short run, the firm chooses its outut so that marginal cost MC is eual to rice as long as the firm covers its average variable cost. Accordingly the short-run suly curve is given by the crosshatched ortion of the marginal cost curve. 299 From the rofit maximization to the suly curve in the short run The effect of change of inut rices on firm short run marginal costs When the marginal cost of roduction for a firm increases (from MC 1 to MC 2 ), the level of outut that maximizes rofit falls (from 1 to 2 ). The shaded area in the figure gives the total savings to the firm (or euivalently, the reduction in lost rofit) associated with the reduction in outut from 1 to

7 From the rofit maximization to the suly curve in the short run From the firm to the industry suly The short-run industry suly curve is the summation of the suly curves of the individual firms. Because the third firm has a lower average variable cost curve than the first two firms, the market suly curve S begins at rice P 1 and follows the marginal cost curve of the third firm MC 3 until rice euals P 2, when there is a kink. For P 2 and all rices above it, the industry uantity sulied is the sum of the uantities sulied by each of the three firms. Q 301 From the rofit maximization to the suly curve in the short run From the firm to the industry suly The short-run industry suly curve is the summation of the suly curves of the individual firms. Because the third firm has a lower average variable cost curve than the first two firms, the market suly curve S begins at rice P 1 and follows the marginal cost curve of the third firm MC 3 until rice euals P 2, when there is a kink. For P 2 and all rices above it, the industry uantity sulied is the sum of the uantities sulied by each of the three firms. Q 302 7

8 From the rofit maximization to the suly curve in the short run Examle: The short run world suly of coer. The suly curve for world coer is obtained by summing the marginal cost curves for each of the major coer-roducing countries. The suly curve sloes uward because the marginal cost of roduction ranges from a low of 65 cents in Russia to a high of $1.30 in Canada. 303 Firm and industry surlus in the short run Producer surlus is an economic measure of the difference between the amount a roducer of a good receives and the minimum amount the roducer is willing to accet for the good. The difference, or surlus amount, is the benefit the roducer receives for selling the good in the market. The roducer surlus for a firm is measured by the yellow area below the market rice and above the marginal cost curve, between oututs 0 and *, the rofit-maximizing outut. Alternatively, it is eual to rectangle ABCD because the sum of all marginal costs u to * is eual to the variable costs of roducing *. Firm PS Producer surlus = PS = RT VC Profit = π = RT VC FC 304 8

9 Firm and industry surlus in the short run The roducer surlus for a market is the area below the market rice and above the market suly curve, between Industry 0 and outut Q*. PS 305 Long run cometitive euilibrium The illars. With low barriers to entry, if the industry is making an economic rofit there is an incentive for other firms to enter the business. As more firms enter, the suly of the roduct increases, driving down the rice and reducing the rofits. This will continue until the firm s economic rofit is reduced to zero. At an economic rofit of zero, firms are still earning a normal rofit, which is a return sufficient to maintain the resources in their current use. Entry and exit. In a market with entry and exit, a firm enters when it can earn a ositive long-run rofit and exits when it faces the rosect of a long-run loss. Long-run cometitive euilibrium. All firms in an industry are maximizing rofit, no firm has an incentive to enter or exit, and rice is such that uantity sulied euals uantity demanded

10 Long run cometitive euilibrium The illars (continued). A long-run cometitive euilibrium occurs when three conditions hold: All firms in the industry are maximizing rofit. No firm has an incentive either to enter or exit the industry because all firms are earning zero economic rofit. The rice of the roduct is such that the uantity sulied by the industry is eual to the uantity demanded by consumers. Q Initially the long-run euilibrium rice of a roduct is $40 er unit, shown in (b) as the intersection of demand curve D and suly curve S 1. In (a) we see that firms earn ositive rofits because long-run average cost reaches a minimum of $30 (at 2 ). Positive rofit encourages entry of new firms and causes a shift to the right in the suly curve to S 2, as shown in (b). The long-run euilibrium occurs at a rice of $30, as shown in (a), where each firm earns zero rofit and there is no incentive to enter or exit the industry. 307 Long run cometitive euilibrium The illars (continued). A long-run cometitive euilibrium occurs when three conditions hold: All firms in the industry are maximizing rofit. No firm has an incentive either to enter or exit the industry because all firms are earning zero economic rofit. The rice of the roduct is such that the uantity sulied by the industry is eual to the uantity demanded by consumers. Q Initially the long-run euilibrium rice of a roduct is $40 er unit, shown in (b) as the intersection of demand curve D and suly curve S 1. In (a) we see that firms earn ositive rofits because long-run average cost reaches a minimum of $30 (at 2 ). Positive rofit encourages entry of new firms and causes a shift to the right in the suly curve to S 2, as shown in (b). The long-run euilibrium occurs at a rice of $30, as shown in (a), where each firm earns zero rofit and there is no incentive to enter or exit the industry

11 Industry cost structure and the shae of the long run suly curve. Increasing-cost industry. When demand increases, initially causing a rice rise, the firms increase their outut from 1 to 2 in (a). In that case, the entry of new firms causes a shift to the right in suly from S 1 to S 2. Because inut rices increase as a result, the AC and the MC shift uward and the new long-run euilibrium occurs at a higher rice than the initial euilibrium. Q In an increasing-cost industry, the long-run industry suly curve is uward sloing. 309 Industry cost structure and the shae of the long run suly curve. Costant-cost industry. When demand increases, initially causing a rice rise (reresented by a move from oint A to oint C), the firm initially increases its outut from 1 to 2, as shown in (a). But the entry of new firms causes a shift to the right in industry suly. Because inut rices are unaffected by the increased outut of the industry, the AC and MC do not change and entry occurs until the original rice is obtained (at oint B in (b)). The long-run suly curve for a constant-cost industry is, a horizontal line at a rice that is eual to the long-run minimum average cost of roduction. 310 Q 11

12 Industry cost structure and the shae of the long run suly curve. Increasing, Costant and decreasing cost industry. The suly of coffee is extremely elastic in the long run. The reason is that land for growing coffee is widely available and the costs of lanting and caring for trees remains constant as the volume grows. Thus, coffee is a constant-cost industry. The oil industry is an increasing-cost industry because there is a limited availability of easily accessible, large-volume oil fields. Finally, a decreasing-cost industry. In the automobile industry, certain cost advantages arise because inuts can be acuired more chealy as the volume of roduction increases. By emloying grahics individuate the long run suly curve in an decreasing-cost industry