Competitive firms and markets. Introduction. Profit maximization Behavior of a firm in a competitive market: In the short run (SR) In the long run (LR). Profit maximization. π (q) = R(q) – C(q) 2 steps: What is the output level, q*, which maximizes profits (minimises losses) ?
π(q) = R(q) – C(q)
What do you think is the typical shape of a profit curve?
At q*, what is the slope of this curve?
A firm maximizes profits when:
MC = MR
market structureCompetition in the short run
MC = MR
Yet, R = p x q
and « price taker »
Hence, profit is max if:
MC = _____
MR = ____
Compute the value of this maximum profit?Profit maximization (graph.)
1. Short-run behavior
Should a firm shut down if π(q*) < 0 ?
Ex1: At q*, R = $2,000, VC = $1,000 and F = $3,000
Ex2: At q*, R = $500, VC = $1,000 and F = $3,000
A firm should continue to operate in the short run if its revenue covers its variable cost.
Shutdown if: R < VC
Shutdown if R < VC P x q < VC
P < VC / q
Shutdown if P < AVC
π > 0
π < 0
π < 0
Draw the firm’s supply curve.
Horizontal sum of individual firms’ supply curves (like D)
Ex: 2 firms, Q = q1 + q2.
S = s1 + s2
Similar to the price elasticity of demand:
Interpretation: The price elasticity of supply represents the percentage change in Qs when P changes by 1%.
% change in Qs∆Qs/QsEsp = --------------------------- = ---------------- % change in P ∆P/P
2. Long-run behavior
Recall: all costs are variable
(selling below cost is not sustainable in the long-run).
Hence, shutdown if R < C π < 0.
In the LR, a firm only produces if it does not incur any losses
As before: horizontal sum of individual curves…
BUT… how many firms are there?
p = min ACLR
Recall: We’re talking about economic profit
(π= πaccounting – Copportunity)
π < 0 I could earn more money elsewhere
Hence, when π = 0, the firm « makes money » (πaccounting > 0), but no more than it would if it utilized its resources differently: it is making normal profits.
A pizza shop in a perfectly competitive environment with the following total costs produces six pizzas.
Quantity Total Costs ($)
What is the price of a a pizza in this industry?
Perfect competition Firm is a price taker so it sets q such that MC=P
Quantity Total Costs ($) MC
0 10 ---
1 15 5
2 25 10
3 40 15
4 60 20
5 85 25
6 115 30
7 150 35
At q=6, MC=30, the price is 30$
You operate Econsultants. One of your clients, Handspring, has recently decided to start a cell phone division in addition to producing handheld personal organizers. Unfortunately, this division of the company is not doing as well as they had hoped and has asked you to assess whether or not they should continue to operate in the short run. The current market price for a cell phone is $100/phone and at this price, Handspring would like to supply 100 phones. However, at a quantity of 100 phones, Handspring has an ATC of $110/phone and an AVC of $75/phone. Starting a cell phone division involved many one-time costs (i.e. the building of factories). In the short run, would you suggest that Handspring continue to operate this division of the company? Explain your answer.
Operate in SR or not? Represent graphically.
P=100$ q=100 ATC=110$ AVC=75$
The question assumes that q is such that P=MC, the firm is optimizeing.
SR decision is P > than AVC?
Yes Operate in the short run to eat some of the fixed costs.
The owner of a firm wants to know if it should change the level of output and/or if it should stay in the business in the short and long run. You are given the following information.
Rev=3,000$ AVC is @ min
FC=500$ TC=3125$ P=40$
1. Is P=MC?
MC=AVC because it is @ min. We need AVC.
AVC=VC/Q, We need Q.
P (40$) > AVC (35$)!!!!! This means that the level of output is not chosen optimally. Output needs to be raised before decisions about SR and LR are to be taken.