The Competitive Firm

1
The Competitive Firm
2
Introduction

• This chapter addresses the following key
  questions
• What are profits?
• What are the unique characteristics of
  competitive firms?
• How much output will a competitive firm produce?

3
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.

4
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.

5
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.

6
Economic 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.

7
ECONOMIC COSTS
Economic Costs or Opportunity Costs Forgoing the
opportunity to produce alternative goods and
services
Explicit Costs Implicit Costs
8
ECONOMIC COSTS
Normal Profits

• Treated as a cost
• Required to attract retain resources

Economic or Pure Profits
9
ECONOMIC COSTS
Profits to an Economist
Profits to an Accountant
T O T A L R E V E N U E
10
ECONOMIC COSTS
Profits to an Economist
Profits to an Accountant
T O T A L R E V E N U E
11
ECONOMIC COSTS
Profits to an Economist
Profits to an Accountant
T O T A L R E V E N U E
12
ECONOMIC COSTS
Profits to an Economist
Profits to an Accountant
T O T A L R E V E N U E
Implicit Costs
Economic (opportunity) Costs
13
ECONOMIC COSTS
Profits to an Economist
Profits to an Accountant
T O T A L R E V E N U E
Implicit Costs
Economic (opportunity) Costs
14
Economic Profits
15
FOUR MARKET MODELS
Pure Competition
Market Structure Continuum
16
FOUR MARKET MODELS
Pure Monopoly
Pure Competition
Market Structure Continuum
17
FOUR MARKET MODELS
Imperfect Competition
Pure Monopoly
Pure Competition
Market Structure Continuum
18
FOUR MARKET MODELS
Monopolistic Competition
Pure Monopoly
Pure Competition
Market Structure Continuum
19
FOUR MARKET MODELS
Oligopoly
Pure Monopoly
Pure Competition
Monopolistic Competition
Market Structure Continuum
20
FOUR MARKET MODELS
Pure Competition

• Very Large Numbers
• Standardized Product
• Price Takers
• Free Entry and Exit

Pure Monopoly
Pure Competition
Monopolistic Competition
Oligopoly
Market Structure Continuum
21
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Perfectly Elastic Demand
Price Taker Role
Total Revenue
P x Q
Average Revenue
TR/Q P
Marginal Revenue
P
For example...
22
Market Demand Curves vs. Firm Demand Curves
The T-shirt market
Market supply
pe
pe
Market demand
23
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
131
0
0
24
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
131 131
0 1
0 131
131
25
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
131 131 131
0 1 2
0 131 262
131 131
26
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
131 131 131 131
0 1 2 3
0 131 262 393
131 131 131
27
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
131 131 131 131 131
0 1 2 3 4
0 131 262 393 524
131 131 131 131
28
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
131 131 131 131 131 131 131 131 131 131 131
0 1 2 3 4 5 6 7 8 9 10
0 131 262 393 524 655 786 917 1048 1179 1310
131 131 131 131 131 131 131 131 131 131
29
DEMAND AS SEEN BY APURELY COMPETITIVE SELLER
Product Price (P) (Average Revenue)
Total Revenue (TR)
Marginal Revenue (MR)
Quantity (Q)
Graphically Presented
131 131 131 131 131 131 131 131 131 131 131
0 1 2 3 4 5 6 7 8 9 10
0 131 262 393 524 655 786 917 1048 1179 1310
131 131 131 131 131 131 131 131 131 131
30
DEMAND, MARGINAL REVENUE, AND TOTAL REVENUE IN
PURE COMPETITION
TR
1179 1048 917 786 655 524 393 262 131 0
Price and revenue
D MR
1 2 3 4 5 6 7
8 9 10
Quantity
31
SHORT RUN PROFIT MAXIMIZATION

• The Decision Process
• Should the firm produce?
• What quantity should be produced?
• What profit or loss will be realized?

The Decision Rule Produce in the short-run if it
can realize 1- A profit (or) 2- A loss less
than its fixed costs
Two Approaches...
First Total-Revenue -Total Cost Approach
32
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100
0
100 190 270 340 400 470 550 640 750 880 1030
33
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100 - 59
0 131
100 190 270 340 400 470 550 640 750 880 1030
34
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100 - 59 - 8
0 131 262
100 190 270 340 400 470 550 640 750 880 1030
35
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100 - 59 - 8 53
0 131 262 393
100 190 270 340 400 470 550 640 750 880 1030
36
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100 - 59 - 8 53 124
0 131 262 393 524
100 190 270 340 400 470 550 640 750 880 1030
37
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100 - 59 - 8 53 124 185 236 277
298 299 280
0 131 262 393 524 655 786 917 1048 1179 1310
100 190 270 340 400 470 550 640 750 880 1030
38
TOTAL REVENUE-TOTAL COST APPROACH
Total Fixed Cost
Total Variable Cost
Price 131
Total Cost
Total Product
Total Revenue
Profit
100 100 100 100 100 100 100 100 100 100 100
0 1 2 3 4 5 6 7 8 9 10
0 90 170 240 300 370 450 540 650 780 930
- 100 - 59 - 8 53 124 185 236 277
298 299 280
0 131 262 393 524 655 786 917 1048 1179 1310
100 190 270 340 400 470 550 640 750 880 1030
39
TOTAL REVENUE-TOTAL COST APPROACH
Break-Even Point (Normal Profit)
1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1
,000 900 800 700 600 500 400
300 200 100 0
Total Revenue
Maximum Economic Profits 299
Total revenue and total cost
Total Cost
Break-Even Point (Normal Profit)
1 2 3 4 5 6 7 8 9 10 11 12
13 14
40
SHORT RUN PROFIT MAXIMIZATION
Two Approaches...
First Total-Revenue/Total Cost Approach
Second Marginal-Revenue/Marginal Cost Approach
MR MC Rule

• Two Characteristics
• Rule applies to all markets
• For perfectly competitive firms, the rule can be
  restated PMC

41
Marginal Cost

• A firms goal is not to maximize revenues, but to
  maximize profits.
• Marginal revenue is compared to marginal costs to
  determine the best level of output.

42
Marginal Cost

• What an additional unit of output brings in is
  its marginal revenue (MR).

• What it costs to produce is its marginal cost
  (MC).

43
Profit-Maximizing Rate of 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.

44
Short-Run Profit-Maximization Rules for
Competitive Firm
Price gt MC increase output Price MC
maintain output and maximize profit Price lt
MC decrease output
45
MARGINAL REVENUE-MARGINAL COST APPROACH
Average Total Cost
Average Fixed Cost
Average Variable Cost
Price Marginal Revenue
Total Economic Profit/Loss
Total Cost
Total Product
Marginal Cost
0 1 2 3 4 5 6 7 8 9 10
100.00 50.00 33.33 25.00 20.00 16.67 14.29
12.50 11.11 10.00
90.00 85.00 80.00 75.00 74.00 75.00 77.14 81.25
86.67 93.00
190.00 135.00 113.33 100.00 94.00 91.67 91.43 93
.75 97.78 103.00
- 100 - 59 - 8 53 124 185 236 277
298 299 280
131 131 131 131 131 131 131 131 131 131
90 80 70 60 70 80 90 110 130 150
100 190 270 340 400 470 550 640 750 880 1030
46
MARGINAL REVENUE-MARGINAL COST APPROACH
Average Total Cost
Average Fixed Cost
Average Variable Cost
Price Marginal Revenue
Total Economic Profit/Loss
Total Cost
Total Product
Marginal Cost
Graphically
0 1 2 3 4 5 6 7 8 9 10
100.00 50.00 33.33 25.00 20.00 16.67 14.29
12.50 11.11 10.00
90.00 85.00 80.00 75.00 74.00 75.00 77.14 81.25
86.67 93.00
190.00 135.00 113.33 100.00 94.00 91.67 91.43 93
.75 97.78 103.00
- 100 - 59 - 8 53 124 185 236 277
298 299 280
131 131 131 131 131 131 131 131 131 131
90 80 70 60 70 80 90 110 130 150
100 190 270 340 400 470 550 640 750 880 1030
47
MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
200 150 100 50 0
Economic Profit
MC
MR
131.00
ATC
Cost and Revenue
AVC
97.78
1 2 3 4 5 6 7 8 9 10
48
MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
200 150 100 50 0
Economic Profit
MC
MR
131.00
ATC
Cost and Revenue
AVC
97.78
1 2 3 4 5 6 7 8 9 10
49
MARGINAL REVENUE-MARGINAL COST APPROACH
Loss Minimization Position
If the price is lowered from 131 to 81
The MRMC rule still applies
But the MR MC point changes
50
MARGINAL REVENUE-MARGINAL COST APPROACH
Loss Minimization Position
200 150 100 50 0
Economic Loss
MC
ATC
Cost and Revenue
AVC
91.67
MR
81.00
1 2 3 4 5 6 7 8 9 10
51
The Shutdown Decision

• The short-run profit maximization rule does not
  guarantee any profits.
• Fixed costs must be paid even if all output
  ceases.
• A firm should shut down only if the losses from
  continuing production exceed fixed costs.

52
MARGINAL REVENUE-MARGINAL COST APPROACH
Short-Run Shut Down Point
200 150 100 50 0
MC
ATC
Cost and Revenue
AVC
MR
71.00
Minimum AVC is the Shut-Down Point
1 2 3 4 5 6 7 8 9 10
53
The Investment Decision

• The investment decision is the decision to build,
  buy, or lease plant and equipment.
• It also involves the decision to enter or exit an
  industry.

54
The Investment Decision

• The shut-down decision is a short-run response.

• Investment decisions are long-run decisions.
• Long-run A period of time long enough for all
  inputs to be varied (no fixed costs).

55
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost Short-Run Supply
Observe the impact upon profitability as price is
changed
Quantity Supplied
Maximum Profit () Or Minimum Loss (-)
Price
151 131 111 91 81 71 61
10 9 8 7 6 0 0
480 299 138 -3 -64 -100 -100
56
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost Short-Run Supply
MC
MR5
P5
ATC
MR4
P4
Cost and Revenue, (dollars)
AVC
MR3
P3
MR2
P2
MR1
P1
Do not Produce Below AVC
Q2
Q3
Q4
Q5
Quantity Supplied
57
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost Short-Run Supply
Yields the Short-Run Supply Curve
Supply
MC
MR5
P5
MR4
P4
Cost and Revenue, (dollars)
MR3
P3
MR2
P2
MR1
P1
No Production Below AVC
Q2
Q3
Q4
Q5
Quantity Supplied
58
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.

59
Determinants of Supply

• The quantity of a good supplied is affected by
  all forces that alter marginal cost.
• The determinants of a firms supply include
• The price of factor inputs.
• Technology (the available production function).
• Expectations (for costs, sales, technology).
• Taxes and subsidies.

60
Supply Shifts

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

61
Taxing Business

• Some tax changes alter short-run supply behavior.
• Others affect only long-run supply decisions.

62
Payroll Taxes

• Payroll taxes increase marginal costs.
• They reduce the profit maximizing rate of output.
• They increase average costs and lower total and
  per-unit profits.

63
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost Short-Run Supply
pe
Higher Costs Move the Supply Curve to the Left
q1
64
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost Short-Run Supply
MC2
S2
ATC2
pe
q2
q1
65
Property Taxes

• Property taxes are a fixed cost.
• They raise average costs and reduce profit.
• Because they dont affect marginal costs, they
  leave the profit-maximizing output unchanged.

66
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost Short-Run Supply
ATC2
pe
q1
67
Profit Taxes

• Profit taxes are neither a fixed cost nor a
  variable cost.
• They dont affect marginal cost or prices.
• They dont affect production level decisions but
  may affect investment decisions.

68
The Competitive Firm

• End of Chapter 7