DYNAMIC POWERPOINT™ SLIDES BY SOLINA LINDAHL
CHAPTER
11
Costs and Profit Maximization
Under Competition
1
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
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questions
2
Food for Thought….
Some good blogs and other sites to get the juices flowing:
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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.
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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
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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)
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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?
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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.
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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.
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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.
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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
0
1
2
3
4
5
6
7
8
9
10
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If Market Price Changes, So Does ProfitMaximizing Quantity
Price
MC
$100
MR = P
$50
MR = P
Quantity
0
1
2
3
4
5
6
7
8
9
10
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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
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Profits and the Average Cost Curve
Quantity
MR =
Price
TR
0
$0
1
Change in
Profit
Average
Cost
TC
Profit
MC
0
30
-$30
0
$0
0
$50
50
34
$16
4
$46
34.0
2
$50
100
40
$60
6
$44
20.0
3
$50
150
51
$99
11
$39
17.0
4
$50
200
68
$132
17
$33
17.0
5
$50
250
91
$159
23
$27
18.2
6
$50
300
120
$180
29
$21
20.0
7
$50
350
156
$194
36
$14
22.29
8
$50
400
206
$194
50
$0
25.75
9
10
Maximum profit is here
$50
450
296
$154
90
-$40
32.89
$50
500
420
$80
124
-$74
42.0
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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
0
1
2
3
4
5
6
7
8
9
10
BACK TO
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.
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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
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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
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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.
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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.
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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.
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“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.
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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.
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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
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•They are equally profitable
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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!
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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!
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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.).
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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
0
0
-$100
Stay Open
$100
$50
$75
-$75
He’ll stay in business… for now.
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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.
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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.
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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.
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Deriving Industry Supply Curves
Price
Price
MC1
MC2
AC2
$50
AC1
$29
$17 $
0 1
Quantity
2
3
4
5
6
7
8
9
10
Firm 1
0 1
2
3
4
5
6
7
Firm 2
$50
S
8
9
10
Quantity
S
Quantity Supplied by the Industry is the Sum of the Quantities Supplied
by Each Firm at Every Price
$29
$17
0 1
q
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17
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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.
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Increasing, Constant, and
Decreasing Cost Industries
Price
Supply, Increasing Cost Industry
Supply, Constant Cost Industry
Supply, Decreasing Cost Industry
Demand
Quantity
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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.
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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…
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How a Constant Cost Industry Adjusts to an
Increase in Demand
And Profits are driven back
down.
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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.
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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
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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.
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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
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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.
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