Ch 11: Costs and Profit Maximization Under Competition

Firms decisions under competition

What price do I set

What quantity do I produce

When do I enter the industry? When do I exit

What price to set?

• easy under perfect competition

• To maximize profit in a competitive market, sell at the market price

elasticity of demand

the more and better the substitutes, the more elastic the demand

Characteristics of perfect competition

the demand for a firm’s product is perfectly elastic at the market price

• similar products across different firms, many buyers and sellers, each small relative to the total market

Examples of Perfect Competition

gold, wheat, paper, steel, lumber, cotton, sugar, vinyl, milk, trucking, glass, internet domain name registration

long run

the time after all entry or exit has occurred

short run

the period before entry or exit can occur

Perfect competition is a reasonable assumption under these conditions

• the product being sold is similar across sellers

• there are many buyers and sellers, each small relative to the total market

• there are many potential sellers

Things to ignore when maximizing profits

• ignore sunk costs

• ignore fixed costs in the short run but not in the long run

Things to focus on when maximizing profits

• opportunity costs

• Explicit costs

• implicit costs

Remember: firms maximize economic profits

explicit costs

costs that require money outlays

implicit costs

costs that do not require money outlays

accounting profit

do not take into account opportunity costs

equal to total revenue minus explicit costs

Economic profit

total revenue minus total costs, including implicit opportunity costs

Profit Formulas

Total Revenue - total costs

(Price - Average Costs) x Quantity

Total revenue

price times quantity sold

P x Q

Total cost

the cost of producing a given quantity o f output

Total cost formula

Fixed Costs + Variable Coss

Fixed Costs

costs that do not vary with output

Variable costs

costs that vary with output

Marginal revenue (MR)

the change in total revenue from selling an additional unit

Marginal Revenue Formula

change in TR/change in Q

Marginal Cost

the change in total cost from producing an additional unit

fixed costs do not impact these costs

Marginal Cost Formula

change in TC/change in Q

Using Marginal to Maximize Profits

we should produce as long as MR > MC

the last unit produced should be the one where MR = MC

Profit maximization rule

produce up until the quantity where MR = MC

for firms in competitive industries, this means to produce up to the quantity where P = MC

when the market price increases, firms should produce more

Profit Maximization Explanation

a firm can maximize profits and still have low/negative profits

Just because a firm is doing the best it can doesn’t mean it is doing very well

Average cost of production

the cost per unit; the total cost of producing Q unites divided by Q

Average Cost of Production Formula

AC = TC/Q

Marginal Cost curve

crosses the average cost curve at its minimum point

Firms will enter the industry

when expected profits are positive (P>AC)

Firms will exit the industry

when expected profits are negative (P < AC)

There is no incentive to enter or exit

when profits are 0 (P = AC)

Zero Profits

these are what non-economists refer to as normal profits

they occur when P = AC

When a firm earns these profits, the price of output is just enough for the firm to cover all its costs, including enough to pay labor and capital their ordinary opportunity costs

A firm is taking a loss

when TR < TC

In the short run

a firm must pay its fixed costs whether it is operating or not

• monthly/daily rent that you may not be able to stop paying immediately

in this time period, a firm’s only choice is whether to shut down and fixed costs should not influence this decision

Shut down scenario

A firm should shut down immediately (in the short run) only if total revenue < variable costs

Also shut down if P < AVC

Summary of entry, exit, and shut down decisions

• If the price is below the minimum of AVC, then the firm should shut down immediately

• If the price is above AVC but below AC, then the firm should continue producing where P = MC but exit ASAP

• If price is at or above AC, the firm should continue producing where P = MC or enter if it is not already in the industry

Shutdown Rule isn’t just about future (long-run) exit

• you may thing of shutting down even when long-run exit isn’t on your radar

• seasonal businesses make their money during the summer (busy) season and may choose to shut down in the winter for a few months

increasing cost industry

an industry in which industry costs increase with greater output

shown with an upward sloping supply curve

greater quantities can be produced only by using more expensive methods

any industry that buys a large fraction of the output of an increasing cost industry will also be an increasing cost

Constant cost industry

an industry in which industry costs do not change with greater output; shown with a flat supply curve

Two characteristics of a constant cost industry

1. Meets the conditions for a competitive industry

   1. the product is similar across sellers

   2. there are many potential buyers and sellers, each small relative to the total market

   3. there are many potential sellers

2. It demands only a small share of its major inputs

   1. the industry can expand or contract without changing the prices of its inputs

Example of a constant cost industry

domain name registration, spoons, waiters

Implications of a constant cost industry

price is driven down to AC, so profits are driven down to normal levels

price doesn’t change much because AC (for each firm in the industry) doesn’t change much when the industry expands or contracts

Decreasing cost industries

• pretty uncommon

• an industry in which costs decrease with greater output

  • shown as a downward sloping supply curve

• As the industry grows, suppliers of inputs more into the area, decreasing costs

• Cost reductions are temporary

• Once the cluster is established, constant or increasing costs are the norm

Examples of Decreasing Cost Industries

carpets in Dalton, Georgia, Silicon Valley, Aalsmeer flower market

Examples of increasing cost industries

oil, steel, nuclear physicists