Costs and Profit Maximization Under Competition

Transcription

1 DYNAMIC POWERPOINT SLIDES BY SOLINA LINDAHL CHAPTER 11 Costs and Profit Maximization Under Competition 1

2 CHAPTER OUTLINE What Price to Set? What Quantity to Produce? Profits and the Average Cost Curve Entry, Exit, and Shutdown Decisions Entry, Exit, and Industry Supply Curves For applications, click here To Try it! questions 2

3 Food for Thought. Some good blogs and other sites to get the juices flowing: 3

4 The Big Questions How do firms behave? The assumption: Profit is the main motivation for firms actions. How do firms maximize profit? By controlling their variables: Price (if possible) Quantity Cost Some firms have more control over prices than others.

5 Competitive Firms Let s focus on one type of firm: the Competitive Firm Characteristics: The product is similar across sellers There are many buyers and sellers, each small relative to the total market Or There are many potential sellers

6 What Price to Set? Competitive firms have no price control: The market determines each firm s price The Market for Oil Price Price The Demand for Your Oil Market Supply Demand for Your Oil $50 Market Demand 82,000,000 Quantity (barrels) The demand for your oil is perfectly elastic Quantity (barrels)

7 Try it! If you were a wheat farmer, what would happen if you set your price above the other 1,000 farmers wheat prices? Why wouldn t you set your price below the market price? What kind (slope) of demand curve does this firm face? How can a firm that produces oil face a very elastic demand curve when the demand for oil is inelastic? To next Try it!

8 What Quantity to Produce? Firms look for ways to maximize profit Profit = p = Total Revenue Total Cost Total Revenue = Price x Quantity (P x Q) Total Cost has two parts: Fixed Costs are costs that do not vary with output. Variable Costs are costs that do vary with output. Total Cost = Fixed Costs + Variable Costs Since a firm in a competitive market must sell its output at the market price, profit maximization depends only on the firm s output decision.

9 The Profit-Maximizing Quantity Each time the firm produces another unit there are extra costs and extra revenues. Profit-maximization is about comparing the extra revenues to the extra costs at the margin. Marginal Revenue (MR) = the change in total revenue from selling an additional unit of output. Marginal Cost (MC) = the change in total cost from producing an additional unit of output.

10 The Profit-Maximizing Quantity What quantity maximizes p? p is maximized by producing where MR = MC. Why? Because if MR > MC, producing more will add to your profit. And if MR < MC, producing less will add to your profit. Since MR = P for competitive firms, the profitmaximizing rule becomes produce where P = MC.

11 The Shape of MR and MC MC rises with production because it gets more costlywe to sell, produce each MR is constant because no matter how much the next additional unit e.g. more equipment, more maintenance, etc. unit will always sell for the market price. Profit is Maximized Where P = MC Price 150 MC 100 Maximum Profit Less Profit 50 MR = P More Profit Quantity

12 If Market Price Changes, So Does ProfitMaximizing Quantity Price MC $100 MR = P $50 MR = P Quantity

13 Profits and the Average Cost Curve We now know how to find the profitmaximizing quantity, now it s time to ask: What is the size of the profit? Average Cost of Production = the total cost of producing Q units of output divided by Q

14 Profits and the Average Cost Curve Quantity MR = Price TR 0 $0 1 Change in Profit Average Cost TC Profit MC $30 0 $0 0 $ $16 4 $ $ $60 6 $ $ $99 11 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Maximum profit is here $ $ $ $ $ $

15 Calculating Profits Since AC = (TC/Q) we can rearrange to find TC = AC x Q We know that p = TR TC, and TR = (P x Q), so substituting in the TC equation gives us: p = (P AC) x Q Price MC $50 P Profit = $194 = ($50- $25.75) X 8 MR = P Average Cost (AC) $25.75 AC $17 Quantity

16 Try it! If a firm is earning positive economic profit, it must be the case that a)price is less than average cost. b)price is equal to average cost. c)price is equal to total cost. d)price is greater than average cost. To next Try it!

17 Try it! Ralph opened a small shop selling bags of trail mix. The price of the mix is $5, and the market for trail mix is very competitive. At what quantity will Ralph produce? a)7 b)10 c)14 d)18 To next Try it!

18 Try it! Ralph opened a small shop selling bags of trail mix. When the price is $5, how much profit will Ralph make? a)$0 b)$14 c)$52 d)$68 To next Try it!

19 Marginal and Average Cost Curve The MC curve intersects the AC curve at its minimum point. When marginal cost is just below average cost, the AC curve is falling. When marginal cost is just above average cost, the AC curve is rising. So, AC and MC curves must meet at the minimum of the AC curve.

20 When to Enter and Exit an Industry In competitive markets a firm will be profitable when P > AC and unprofitable when P < AC. So, in the long run, firms will enter profitable industries (P > AC ) and will exit unprofitable ones (P < AC). Note that at the intermediate point (P = AC) profits are zero, and there is no entry or exit.

21 Zero Profits Economists refer to Zero Profits or normal profits as the profit level where the firm is covering all of its costs including enough to pay labor and capital their opportunity costs.

22 Economic vs. Accounting Profit Remember, not all costs require monetary payment! An explicit cost is a cost that requires a money outlay. An implicit cost is a cost that does not requires an outlay of money. Economic profit is total revenue minus total costs including implicit costs. Accounting profit is total revenue minus explicit costs. 22

23 Zero Profits Example: if you quit your job as a lion tamer ($45,000/year income) to open a tanning studio ($45,000/year left over after costs are paid), what is your economic profit? We would say it s zero: you are earning just enough to cover your costs, including your foregone lion taming wages.

24 Try it! Imagine that Alex and Tyler each decide to drill an oil well in their backyard, which costs $200,000. Alex borrows the $200,000 from a bank at a 5% annual rate of interest so Alex must pay the bank $10,000 per year ($10,000 = 0.05 $200,000). Tyler pays the $200,000 out of a small inheritance he received from a rich uncle. Each well produces $15,000 worth of oil annually. Which well is more profitable (Economic profit)? Alex Tyler To next They are equally profitable Try it!

25 Zero Profits Other examples of implicit costs include foregone rent (if you are using your own property as the tanning studio), foregone interest income (if you use your own life savings as the start-up money) and many others. Firms will need to consider these costs if they want to make good decisions. From now on, we ll assume that our cost curves take these opportunity costs into account. And therefore a zero profit isn t a bad thing!

26 Entry and Exit with Uncertainty and Sunk Costs If P < AC, the firm will exit the industry in the long-run, but what about the shortrun? Will the firm shutdown immediately if price dips below average cost? Not necessarily!

27 Entry and Exit with Uncertainty and Sunk Costs The firm may be earning enough revenue to pay some of its costs If it shuts down it will still have to pay its fixed costs (which may be less than its revenue). Even though it s losing money, It may have enough to cover its variable costs and a portion of its fixed Fortune cookie equipment costs. costs money There may be extra costs to shut down (severance pay, etc.). 27

28 Entry and Exit with Uncertainty and Sunk Costs A firm should stay open in the short run if it can cover its variable costs Decision Fixed Costs Variable Costs Revenue Profit Shutdown $ $100 Stay Open $100 $50 $75 -$75 He ll stay in business for now.

29 Entry and Exit with Uncertainty and Sunk Costs Sunk Cost = a cost that once incurred can never be recovered. If it closes down, this oil company won t recover the cost of this rig.

30 Entry and Exit with Uncertainty and Sunk Costs If a firm could instantly and costlessly enter and exit an industry, then this basic rule applies: enter when P > AC and exit when P < AC. But, when it is costly to enter and exit and there is uncertainty about future prices, firms must make their decisions based on their lifetime expected profit. Note: this estimation can be quite difficult to make, and any error could lead to significant losses.

31 Deriving Industry Supply Curves The industry supply curve is built from the MC curves and the entry and exit decisions of firms. A firm will enter when P > AC and will expand production along its MC curve when price rises above this level. Thus, a firm s supply curve is the portion of the MC curve above the AC curve.

32 Deriving Industry Supply Curves Price Price MC1 MC2 AC2 $50 AC1 $29 $17 $ 0 1 Quantity Firm Firm 2 $50 S Quantity S Quantity Supplied by the Industry is the Sum of the Quantities Supplied by Each Firm at Every Price $29 $ q

33 Deriving Industry Supply Curves The shape of the supply curve for a particular industry is determined by the change in costs as industry output increases or decreases. There are three types of industry supply curves. 1. Increasing Cost Industry = an industry in which costs increase with greater output; shown with an upward sloping supply curve. 2. Constant Cost Industry = an industry in which costs do not change with greater output; shown with a flat supply curve. 3. Decreasing Cost Industry = an industry in which industry costs decrease with greater output; shown with a downward sloping supply curve.

34 Increasing, Constant, and Decreasing Cost Industries Price Supply, Increasing Cost Industry Supply, Constant Cost Industry Supply, Decreasing Cost Industry Demand Quantity

35 Constant Cost Industries Constant cost industries capture two important aspects of competitive markets: 1. Price is quickly driven down to the average cost of production; 2. Firms earn zero (or normal) profit. This does not mean that firms are just breaking even. Remember, the costs of production include the opportunity costs of the inputs used in production. This implies that firms are earning a rate of profit equal to that of any other use of those inputs.

36 How a Constant Cost Industry Adjusts to an Increase in Demand An increase in demand causes prices to rise Which increases profits and attracts new firms

37 How a Constant Cost Industry Adjusts to an Increase in Demand And Profits are driven back down.

38 Short and Long Run The Short Run = the time period before entry occurs. The Long Run = the time it takes for substantial new investment and entry to occur.

39 Try it! How long is the long run? It will vary from industry to industry. How long would you estimate the long run is in the market for electrical engineers? a)2-3 days b)2-3 months c)2-3 years d)more than 2-3 years To next Try it!

40 Increasing Cost Industries As a firm expands production when price rises, the firm will require more inputs. Because these resources are limited, their prices will rise- driving up production costs. An Increasing Cost Industry is an industry characterized by greater costs as production expands. As oil production increases, we tap into highercost oil sources as extraction costs rise. 40

41 Decreasing Cost Industries A Decreasing Cost Industry is an industry characterized by lower costs as production expands. industry clusters help reduce costs as production increases More specialized resources in one place improve each other s efficiency Dalton, Georgia: carpet capital of the world Hollywood, CA, USA: movie capital of the world Silicon Valley, California: a high-tech cluster

42 Try it! In the competitive electrical motor industry, the workers at Galt Inc. threaten to go on strike. In order to avoid the strike, Galt Inc. agrees to pay its workers more. At all other factories, the wage remains the same. What will happen to the number of motors produced by Galt Inc.? a)the number of motors produced will rise. b)the number of motors produced will remain the same. c)the number of motors produced will fall. d)this cannot be determined without more information.