Chapter 11-
Managerial Decisions
in Competitive
Markets
Perfect Competition
Firms are price-takers
Each produces only a very small portion of total
market or industry output
All firms produce a homogeneous product
Entry into & exit from the market is unrestricted
Free entry
Demand and Marginal
Revenue
Demand is perfectly elastic
Demand for a Competitive Price-
Taker
Demand curve is horizontal at price determined by
intersection of market demand & supply
Perfectly elastic
Marginal revenue equals price
Demand curve is also marginal revenue curve (D = MR)
Can sell all they want at the market price
Each additional unit of sales adds to total revenue an amount
equal to price
Demand for a Competitive
Price-Taking Firm
Profit-Maximization in the Short
Run
In the short run, managers must make two
decisions:
Produce or shut down?
If shut down, produce no output and hires no variable
inputs
If shut down, firm loses amount equal to TFC
If produce, what is the optimal output level?
If firm does produce, then how much?
Produce amount that maximizes economic profit
Profit = π = TR − TC
Profit Margin (or Average
Profit)
Level of output that maximizes total profit occurs at
a higher level than the output that maximizes profit
margin (& average profit)
Managers should ignore profit margin (average profit) when
making optimal decisions
Average Profit = π/Q = (P – ATC)*Q / Q
= P – ATC = Profit Margin
The manager should always produce where
MR = MC
For a perfectly competitive firm this also equals price
Profit Margin
The greatest profit margin occurs at point N
Total profit is not being maximized
Profit Maximization
TR = 36*600
TC = 19*600
Total Profit =
17*600 = 10200
At N TP
= 20*400 = 8000
Short-Run Output Decision
Firm’s manager will produce output where P =
MC as long as:
TR ≥ TVC
or, equivalently, P ≥ AVC
If price is less than average variable cost (P <
AVC), manager will shut down
Produce zero output
Lose only total fixed costs
Shutdown price is minimum AVC
Short Run Loss
Short Run Loss (P = $10.50)
Do we operate in the short run?
TR = 10.50 * 300 = 3150
TC = 17 * 300 = 5100
Total Profit = -1950
Is this better than shutting down?
Average fixed costs at 300 units are (17-9 = 8)
Since fixed costs are constant they are 8*300 or
$2400
Shutting down means we lose $2400
Operate in the short run.
Irrelevance of Fixed Costs
Fixed costs are irrelevant in the production
decision
Level of fixed cost has no effect on marginal cost
or minimum average variable cost
Thus no effect on optimal level of output
Summary of Short-Run Output
Decision
AVC tells whether to produce
Shut down if price falls below minimum AVC
SMC tells how much to produce
If P ≥ minimum AVC, produce output at which P
= SMC
ATC tells how much profit/loss if produce
π = (P – ATC) * Q
Short-Run Supply Curves
For an individual price-taking firm
Portion of firms’ marginal cost curve above
minimum AVC
For prices below minimum AVC, quantity supplied
is zero
For a competitive industry
Horizontal sum of supply curves of all individual
firms; always upward sloping
Supply prices give marginal costs of production
for every firm
Short Run Supply Curve
Short-Run Producer Surplus
Short-run producer surplus is the amount by
which TR exceeds TVC
The area above the short-run supply curve that is
below market price over the range of output
supplied
Exceeds economic profit by the amount of TFC
Producer Surplus –
Graphically
Producer Surplus –
Mathematically (P = 9)
Producer Surplus = TR – TVC
= 9 * 110 – 5.55 * 110 = $4.45 * 110 = $380
$5.55 is AVC and $9 is Price
We also can calculate the area on the graph
Area of eabd
The rectangle is = (9-5)*(80) = 320
The triangle is = .5*(4)*(110-80) = 60
PS = $380
Long-Run Competitive
Equilibrium
All firms are in profit-maximizing equilibrium
(P = LMC)
Occurs because of entry/exit of firms in/out of
industry
Market adjusts so P = LMC = LAC
LR Competitive Equilibrium
Since economic profit = 5*240 = 1200
With free entry firms will enter
Long Run Competitive
Equilibrium
After firms enter, supply increases and prices
fall until P = MC = ATC = LAC
Long-Run Industry Supply
Long-run industry supply curve can be flat
(perfectly elastic) or upward sloping
Depends on whether constant cost industry or
increasing cost industry
Economic profit is zero for all points on the
long-run industry supply curve for both types
of industries
Long-Run Industry Supply
Constant cost industry
As industry output expands, input prices remain constant, &
minimum LAC is unchanged
P = minimum LAC, so curve is horizontal (perfectly elastic)
Increasing cost industry
As industry output expands, input prices rise, & minimum
LAC rises
Long-run supply price rises & curve is upward sloping
Long-Run Industry Supply for a
Constant Cost Industry
Perfectly elastic supply
Long-Run Industry Supply for an
Increasing Cost Industry
As supply increases, resource costs increase
causing LAC to increase
Economic Rent
Payment to the owner of a scarce, superior resource
in excess of the resource’s opportunity cost
In long-run competitive equilibrium firms that employ
such resources earn zero economic profit
Potential economic profit is paid to the resource as
economic rent
In increasing cost industries, all long-run producer surplus
is paid to resource suppliers as economic rent
Economic Rent in Long-Run
Competitive Equilibrium
Economic rents are seen when one firm is able to
produce at lower costs (entrepreneur talent)
Profit-Maximizing Input Usage
Profit-maximizing level of input usage
produces exactly that level of output that
maximizes profit
Profit-Maximizing Input Usage
Marginal revenue product (MRP)
MRP of an additional unit of a variable input is the
additional revenue from hiring one more unit of the
input
If choose to produce:
If the MRP of an additional unit of input is greater
than the price of input, that unit should be hired
Employ amount of input where MRP = input price
∆TR
MRP = = P × MP
∆L
Profit-Maximizing Input Usage
Average revenue product (ARP)
Average revenue per worker
Shut down in short run if ARP < MRP
When ARP < MRP, TR < TVC
TR
ARP = = P × AP
L
Profit Maximizing Labor
Usage
Max profit occurs
where MRP =
ARP
