The Competitive Firm

Chapter 7

In this Chapter..

7.1. Market Structure

7.2. Profit Maximization for A firm in Perfectly Competitive Market

7.3. When to Shutdown; and the Supply Curve of a Competitive firm

The Profit Motive

The basic incentive for producing goods and services is the expectation of profit.

Profit is the difference between total revenue and total cost.

Other Motivations

Personal reasons also motivate producers. Producers seek social status and

crave recognition. Non-owner managers of corporations

may be more interested in their own jobs, salaries, and self-preservation than earning profits for stockholders.

Is the Profit Motive Bad?

The profit motive encourages businesses to produce the goods and services consumers’ desire, at prices they are willing to pay.

What Proportion of the Sales Price, do you think, goes to Sellers (Producers) as Profit?

The typical consumer believes that 35¢ of every sales dollar goes to profits.

In reality, average profit per sales dollar is closer to 5¢.

Economic and Accounting Profits

Economic profit is the difference between total revenues and total economic costs.

Economic cost is the value of all resources used to produce a good or service – opportunity cost.

To determine a firm’s economic profit, all implicit factor costs must be subtracted from observed accounting profit.

Economic and Accounting Profits

Economic and Accounting Profits

Economic profits represent something over and above normal profits.

Normal profit is the opportunity cost of capital

A productive activity reaps an economic profit only if it earns more than its opportunity cost.

Economic ProfitsTotal (gross) revenues $27,000 less explicit costs:

Cost of merchandise sold $17,000 Wages to cashier, stock, and delivery help 2,500 Rent and utilities 800 Taxes 700

Total explicit costs $21,000 Accounting profit (revenue minus explicit costs) $ 6,000

less implicit costs

Wages of owner-manager, 300 hours @ $10 per hour $ 3,000 Return on inventory investment, 10% per year on $120,000 1,000 Total implicit costs $ 4,000

Economic profit (revenue minus all costs) $ 2,000

Entrepreneurship The inducement to take on the added

responsibilities of owning and operating a business is the potential for profit.

The potential for profit is not a guarantee of profit.

1. substantial risks are attached to starting and operating a business.

2. The opportunity for profit may be limited by the structure of the industry.

7.1. Market Structure

Market Structure

Market structure refers to the number and relative size of firms in an industry.

Two broad Categories1. Perfectly Competitive 2. Imperfectly Competitive

Market Structure

•Oligopoly•Duopoly

•Monopoly•Monopolisticcompetition

I. PerfectCompetition II. Imperfect competition

I. The Nature of Perfect Competition

Distinguishing characteristics: Many firms – lots of firms are competing

for consumer purchases. Identical products – the products of the

different firms are identical, or nearly so. Low entry barriers – it’s relatively easy

to get into the business. Perfect Information-Every body knows

every thing about the market

Market Structure

Perfect competition is a market in which no buyer or seller has market power.

Price Takers

A perfectly competitive firm has no market power and thus has no ability to alter the market price of the goods it produces.

Market Power – The ability to alter the market price of a good or service.

Price Takers The output of a perfectly competitive

firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market.

Pricing decision is thus beyond the control of the firm

The firm has to decide on how much to produce

Market Demand Curves vs.

The Demand Curves Facing A Firm

Market Demand Curves vs. The Demand Curves Facing A Firm

It is important to distinguish between the market demand curve and the demand curve confronting a particular firm.

Market Demand Curves vs. Firm Demand Curves

The market demand curve for a product is always downward-sloping.

PR

ICE

(per

shi

rt)

Quantity (thousand shirts per day)

Market Demand Curves vs. Firm Demand Curves

Market demand

Market supply

Equilibrium pricepe

The T-shirt market

Market Demand Curves vs. Firm Demand Curves The market demand curve for a

product is always downward-sloping.

However, the demand curve confronting a perfectly competitive firm is horizontal

Quantity (shirts per day)

Demand facing one shop

PR

ICE

(per

shi

rt)

Quantity (thousand shirts per day)

Market Demand Curves vs. Firm Demand Curves

Market demand

Market supply

Equilibrium pricepe

The T-shirt market

peDemand facing single firm

The Production Decision

Thus a competitive firm has only one decision to make: how much to produce.

The production decision is the selection of the short-run rate of output (with existing plant and equipment).

Output and Revenues In searching for the most desirable

rate of output, the distinction between total revenue and total profit must be kept in mind. Total revenue - The price of the

good multiplied by the quantity sold in a given time period.

Total revenue = price X quantity

Output and Revenues

Total Revenue: PXQ

Total Revenue Curve an upward-sloping straight line

The Slope of The TR Curve: pe.

Total revenue

0 1 2 3 4 5 6 7 8 9 10 1112

pe= $8816243240485664728088

$96

Quantity

Tota

l Rev

enue

Total Revenue

Output and Costs

To maximize profits a firm must consider how increased production will affect costs as well as revenues. Producers are saddled with certain

costs in the short-run. Short-run - The period in which the

quantity (and quality) of some inputs cannot be changed.

Output and Costs– Fixed costs - Costs of production that do

not change when the rate of output is altered, e.g., the cost of basic plant and equipment. Fixed costs are incurred even if no output is

produced.-Variable costs - Costs of production that

change when the rate of output is altered, e.g. labor and material costs. Once a firm starts producing output, it incurs

variable costs as well.

Tota

l Cos

t (do

llars

per

tim

e pe

riod)

Output (units per time period)

Total Cost

z

Total cost

Fixed cost

Total costs escalate due to the law of diminishing returns

Output and Costs

The shape of the total cost curve reflects increasing marginal costs and the law of diminishing returns.

Marginal cost is the increase in total costs associated with a one-unit increase in production.

Output and Costs

Given these conditions, the producer’s problem is to find that one particular rate of output that maximizes profits.

Output (units per period)

Rev

enue

s O

r Cos

ts (d

olla

rs p

er p

erio

d)Total Profit

Total cost Total revenue

Profits

Losses

r

s

f h g

Profit-Maximizing Rule

The best single rule for maximizing short-run profits is …

To never produce a unit of output that costs more than it brings in.

What does this means?

Profit-Maximizing Rule The producer has to compare the

contribution of the additional unit of the output to the total revenue with the what it costs to produce that additional unit.

The contribution to total revenue of an additional unit of output is called marginal revenue.

Profit-Maximizing Rule Marginal revenue (MR) is the change

in total revenue that results from a one-unit increase in the quantity sold.

In a perfectly competitive market, MR is simply the price of the product; MR=P

Marginal Revenue = PriceRate ofOutput Price

TotalRevenue

MarginalRevenue

0 $13 $ 01 13 13 $132 13 26 133 13 39 134 13 52 135 13 65 13

Marginal Cost We know that, for a firm in perfectly

competitive market, the price of its product is its marginal revenue.

The firm’s goal is not to maximize revenues, but to maximize profits….To achieve this goal..

… the firm has to compare its Marginal Revenue with its Marginal Costs and determine the best level of output.

Marginal Cost Recall:

Just as what an additional unit of output brings in is the firms marginal revenue (MR);

Marginal cost is what it costs the firm to produce the additional unit of the output

Marginal CostRate ofOutput Total Cost

MarginalCost

AverageCost

0 $101 15 $ 5 $15.002 22 7 11.003 31 9 10.334 44 13 11.005 61 17 12.20

Profit-Maximizing Output a firm should produce at that rate of

output where marginal revenue equals marginal cost.

Max Profit: MR=MC As MR=P; the Profit maximizing Rate of

output is one that can be produced when marginal cost equals the price of the product

P= MC

Profit-Maximizing Output If marginal cost exceeds price, total profits

decline if the additional output is produced.

If marginal cost is less than price, total profits increase if the additional output is produced.

Profits are maximized at the rate of output where price equals marginal cost.

Short-Run Profit-Maximization Rules for Competitive Firm

Price > MC increase outputPrice = MC maintain output

and maximize profitPrice < MC decrease output

Quantity (bushels per day)0 1 2 3 4 5 6 7

2

4

6

8

10

12

14

16

$18

Pric

e or

Cos

t (pe

r bus

hel)

Marginal cost

Price (= MR)

Profit-Maximizing Rate of Output

Profit-maximizing rate of output

MCB

MRBp = MC Profits decreasing

Profits increasing

Adding Up Profits

Profits can be computed in two ways.

1. As a difference between total revenue and total cost.

Total profit = total revenue – total cost

Adding Up Profits

2. As a difference between Price and average total cost times the number sold.

Profit per unit = price – ATC

Total profit = (p – ATC) X q

Alternative Views of Total Profit

0 1 2 3 4 5 6 7

2468

10121416

$18

Rate of Output

Pric

e or

Cos

t (pe

r uni

t)

Price and average cost

Profit per unit

Marginal cost

Total ProfitPrice

Average total cost

Cost per unit

Reve

nue

or C

ost (

dolla

rs p

er d

ay)

Total revenueMaximum total profit

Total cost

0 1 2 3 4 5 6 7

1020304050607080

$90

Rate of Output

Total revenue and total cost

Implication…

The profit-maximizing producer has no desire to produce at that rate of output where ATC is at a minimum.

I.e., profit max output is not necessarily at the point where ATC is the lowest.

The Shutdown Decision In a competitive market, the short-run profit

maximization rule does not guarantee any profits.

It tells the output level that maximizes economic profit.

A firm in such a market thus always want to produce that level of output.

However, a competitive market is characterized by free entry (lack of barriers to entry).

The Shutdown Decision

Economic profits being made by firms already in the market will attract new (more) firms into that business.

Entry of new firms into the market will affect the market supply and thus market price of the good.

As a result, it possible that a firm already in the market could face and economic loss.

When should it shutdown the business?

The Shutdown Decision

A firm should shut down only if the losses from continuing production exceed fixed costs.

It is possible to run a business while incurring losses, as long as the loss doesn’t exceed the fixed cost

The Shutdown Point

However, when price does not cover average variable costs at any rate of output, production should cease.

The shutdown point is that rate of output where price equals minimum AVC.

Open 24 Hours, 7 days a week When price exceeds average variable

cost but not average total cost, the profit maximizing rule minimizes losses.

Think of the Opening and Closing hours of businesses! Some business shutdown after 10Pm other

stay open 24 hours. If MR from sales during later hours pays for

the variable cost of staying open…stay open Other wise shutdown

The Shutdown PointLoss

Quantity0 87654321

MC

AVC

ATC

PriceY

Shutdown

Quantity0 87654321

MC

AVC

ATC

Priceshutdown point

Profit

0

181614

1210

864

2

87654321

Pric

e or

Cos

t

Quantity

MC

AVC

ATCX

Price (=MR)

The Firm’s Supply Curve

In the short run, the firms supply curve is the portion of its MC curve which lies to the right of the shutdown point.

The portion of it marginal cost curve that lies to the right of the point where P=MR=AVC

Short-Run Supply Curve

0 1 2 3 4 5 6 7

2468

10121416

$18

Quantity Supplied (bushels per day)

Pric

e (p

er b

ushe

l)

Marginal cost curve

Short-run supply curve for competitive firm=

Y

X

Shutdown point

Why is Supply curve upward slopping?

Short-Run Supply Curve The marginal cost curve is the short-

run supply curve for a competitive firm.

Supply curve – A curve describing the quantities of a good a producer is willing and able to sell (produce) at alternative prices in a given time period, ceteris paribus.

Determinants of Supply The quantity of a good supplied is

affected by all forces that alter marginal cost. These include: The price of factor inputs. Technology (the available production

function). Expectations (for costs, sales,

technology). Taxes and subsidies.

Supply Shifts

If any determinant of supply changes, the supply curve shifts.

E.g. Tax Effects: Property Taxes Payroll Taxes Profit Taxes

Property Taxes Property taxes are a fixed cost.

They raise average costs and reduce profit.

However, they don’t affect marginal costs. Thus they leave the profit-maximizing output unchanged.

Payroll Taxes Payroll taxes increase marginal costs.

They reduce the profit maximizing rate of output.

Thus they increase not only the average costs but also lower the total and per-unit profits. Thus altering the profit maximizing output level

Profit Taxes Profit taxes are neither a fixed cost nor a

variable cost.

They don’t affect marginal cost or prices.

They don’t affect production level decisions but may affect investment decisions.

Impact of Taxes on Business Decisions

pe

q1

MC1

ATCaATC1

Property taxes affect fixed costs

pe

q1

MC1

ATCbATC1

MCb

qb

Payroll taxes alter marginal costs

pe

MC1

ATC1

q1

Profits taxes don't change costs