Profit Maximizing/Loss Minimizing Output Determination: Pure Competition

1. Profit Maximizing/Loss Minimizing Output Determination: Pure Competition

2. What is Profit Max/Loss Min? • Each firm finds its Cost of Production • Each firm uses that information to determine the Quantity-Supplied at each market price. • The goal for a firm is to supply that quantity that maximizes profit or minimizes losses at each possible market price.

3. Pure Competition Many competitors Price-takers Perfectly elastic demand curve for firm Standardized Product No firm advertising Monopoly No real competition 1 firm controls industry sales Price setter Unique product or market power Not much advertising Downward-sloping demand curve Market Structure

4. Business Structure Sole Proprietorship Partnership Corporation

5. Easy to start Own boss, make all decisions Earn all profits Hard to borrow money for growth Rely on own knowledge, etc. Fully liable for losses Business ends when you die Sole Proprietorship Most frequently started. Most often bankrupt.

6. Easy to start Shared decision-making and work Share profits Hard to borrow money Disagreements with partner Liability may not be limited—may be fully liable for partner’s actions. Partnership

7. Legal person: outlive founder Easier to finance growth [bonds, stocks, borrow, savings] Tax advantages Limited liability Ownership risk spread Harder to start More tax papers to file Management must satisfy shareholders Often separation of owners and management Corporation Most numerous form of successful business

8. Short Run or Long Run • Long run productive capacity is variable. • All Costs are Variable in the Long Run. • You can go out of business forever. • Short run is “however long” your productive capacity is fixed. • Fixed Costs exist in the Short Run. • You can close temporarily but not go out of business.

9. Total Production Costs in the Short Run Production costs are payments to buy or rent the Factors of Production: • Variable Costs • Fixed Costs

10. Variable Costs: increase as output increases & decrease as output decreases. • Payments to Labor • Payments to Land [materials, supplies, etc.] • Sometimes payment to Entrepreneur, if take Normal Profit as X dollars per unit of output. To paint more houses, you use more paint.

11. Fixed Costs remain the same regardless of output • Payments for Capital Goods, such as factories, tools • Sometimes payment to Entrepreneur if takes Normal Profit as X dollars regardless of output.

12. Total Production Costs are based on productivity. Below are the number of workers and units of capital goods used to produce the output at left. Modified version of handout Page 1, bottom table.

13. Marginal Product Table shows that at 0 output you use 0 labor and 10 capital. You must pay for capital even if you don’t use it. Table shows that at 43 output you use 1 labor and 10 capital. You pay for both labor & capital. Table shows that as output increases you use more labor [variable cost] but no more capital [fixed cost.]

14. Marginal Product Table shows that as you add labor, your output increases. The first worker adds 43 units to output so her Marginal Product is 43. The second worker adds 117 units to output so his Marginal Product is 117. Total output for 2 workers is 160. As output increases, Marginal Product will decrease [ the corollary the Law of Increasing Costs]. On your handout, page 1, bottom table MP is 94 for the 10th worker, 65 for the 11th worker and 45 for the 12th worker.

15. Total Variable Cost Figuring Costs: Total Variable Cost = # of laborers times wages [First table, 4th column on page 2 of your handout. You will need to complete it.]

16. Total Fixed Costs Figuring Costs: Total Fixed Cost = # of capital goods times price of capital goods [First table, 3rd column on page 2 of your handout. You will need to complete it.]

17. Total Costs Figuring Costs: Total Cost = Total Variable Cost + Total Fixed Cost. Do for each unit of output. [First table, 5th column on page 2 of your handout. You will need to complete it.]

18. Average Variable Cost Figuring Costs: Average Variable Cost = Total Variable Cost per unit of output divided by unit of output. [First table, 9th column on page 2 of your handout. You will need to complete it.]

19. Average Fixed Cost Figuring Costs: Average Fixed Cost = Total Fixed Cost per unit of output divided by unit of output. [First table, 6th column on page 2 of your handout. You will need to complete it.] Spreading overhead sound familiar?

20. Average Total Cost Figuring Costs: Average Total Cost = Total Cost per unit of output divided by unit of output or add AVC & AFC per unit of output. [First table, 7th column on page 2 of your handout. You will need to complete it.]

21. Marginal Cost Figuring Costs: Marginal Cost = Change in Total Cost divided by change units of output . [First table, 8th column on page 2 of your handout. You will need to complete it.] Next slide puts all the costs together and extends from 0 to 1860 units of output and the slide after that graphs the important cost curves.

22. The whole thing: First table, page 2 modified to include units of Capital

23. What the curves look like Well, this is what the Average Variable, Average Total and Marginal Costs Curves looks like when graphed. Practice!!!!

24. Relationships among Curves Total Fixed Costs are constant in Short Run so AFC always decreases. [not pictured on graph] Total Variable Costs increase as output increases. AVC first decreases as productivity increases, then increases as productivity decreases [law of increasing costs.] Pictured on graph. Total Costs increase as output increases because variable costs do. ATC will first decrease as productivity increases--as shown by decreasing AVC--and always decreasing AFC and then increase because of productivity decreases--as shown by increasing AVC. Because AFC continually decreases the gap between ATC and AVC will narrow. Pictured on graph. Marginal Cost first decreases due to increased productivity and then increases due to decreased productivity. Pictured on graph. Go back to see graph.

25. Ok, are we making a profit? Opps! We need to compare revenues to costs.

26. Revenues in Pure Competition • Total Revenue = Price times Quantity • Average Revenue = Price • Marginal Revenue = Price or Change in Total Revenue divided by Change in Output

27. 4 Major Points • 4 Major Points in Profit maximizing/Loss Minimizing in Short Run. • Shut Down Situation • Firm is losing more money by staying open than it would by shutting down temporarily. It must be able to pay all its Variable Costs and some of its Fixed Costs to stay open in the Short Run. • Acceptable Loss Situation • Firm is paying all of its Variable Costs and some of its Fixed Costs. It will lose less money by staying open than shutting down in the Short Run. • Normal Profit or Breakeven Situation • Firm is paying all of its Variable and Fixed Cost, including the Normal Profit to the Entrepreneur. Capacity indicator for industry. • Economic Profit • Firm has money left over after paying all Variable and Fixed Cost, including Normal Profit to Entrepreneur. Signals industry growth.

28. Profit or Loss To determine Profit or Loss, subtract Total Cost from Total Revenue for each level of output. [Handout page 3 both tables.] The following example shows a situation in which the firm should shut down temporarily in the Short Run to wait for higher prices. The firm is losing more money at each possible market price than it would lose by shutting down. It will only lose $100. [its Total Fixed Costs] if it shuts down temporarily. If it tries to stay open and produce 1656 units of output, what is it’s loss?__________ Examine the Average Variable and Marginal Cost curves in comparison to the Marginal Revenue Curve. You will use this later.

29. Shut Down What you’ll see next is a combined form of the First Table, page 2, and the two Tables on page 3, for $.09 only. Demand for the Purely Competitive Firm is Perfectly Elastic--a straight horizontal line. The Market Price for the product in this Purely Competitive Market is currently $.09. The next slide takes this price of $.09 for each unit of output and uses it to determine Total Revenue [price times quantity] and Marginal Revenue [change in Total Revenue divided by change in quantity] at each level of output. Total Revenue and Marginal Revenue are compared with the Cost curves from the previous section. Don’t panic. It just looks awful. From this analysis, you can see that the firm must shut down temporarily in the Short Run because it loses more money by producing than by not producing.

30. Shut Down Situation No loss less than the $100 with 0 output.

31. Help there has to be an easier way!!! What would you do if the Price were $.12? $.13? $.18? $.22? $.32? Well, you can get new batteries for your calculator and complete the two tables on page 3 for each price or you can do this the easy way.

32. Pure Competition = elastic demand Remember that each new price in a Purely Competitive Industry represents a NEW demand curve which is perfectly elastic. So MR = AR = P. • Find the 4 points on the next table. Identify the relationships among MC, MR, AVC, ATC that give you each of the 4 points. • Shut down • Acceptable Loss • Breakeven or Normal Profit • Economic Profit

33. The EASY WAY!!! The Easy Way: Produce where MR is equal to or slightly greater than MC above lowest AVC [for least loss in Short Run], above lowest ATC [for largest profit in Short Run.]

34. Demand = MR = AR Remember Demand is perfectly elastic[the dotted lines] for purely competitive firms.

35. Short Run Supply Curve = MC above lowest AVC. Short Supply Curve Breakeven Shut down

36. Long Run Supply Curve = MC above lowest ATC. Long Run Supply Curve Remember. No Fixed Costs in Long Run.

37. Ok--Now what about in the Real World where demand curves slope downward? • Pretty much the same thing with one important exception. MR does not equal Price. • Use MR equal to or slightly greater than MC above lowest AVC to find output. • Find Price associated with that output on Table. See table next slide. • On graph [2 slides over], project upward from that output to the demand curve to find the price..

38. Downward sloping Demand MR = MC not P! Whole range is Economic Profits but 1750 output gives Maximum Profit [$522.60]

39. MR [$.29] equal to or slightly greater than MC [$.21] at 1750 units of output. Price is $.47. Hint. Find output then go up to Demand curve to find price. price Output

40. Competitive Lower price for same output 1750 units, price = $.22 At non-competitive firm price [$.47], firm would produce larger output = 1860 units Non-competitive Higher price for same output 1750 units, price = $.47 at Competitive firm price of $.22, firm will not produce. Compare Competitive price/output to non-Competitive

41. If mergers reduce competition in the marketplace, what impact would the proposed mergers in the drug industry have on product price, quantity produced? If companies merge to compete better in a World market, what are the benefits and costs to U.S. customers? To U.S. employees? Real Life Question