4 Profit Maximization This occurs where marginal revenue (MR) = marginal cost (MC). MR = MC Marginal revenue is the extra revenue earned when one additional unit is produced The MC curve is also the firms supply curve
5 Profit Maximization Outcomes If MC < MR, the firm should increase output If MC > MR, the firm should decrease output If Price > ATC, the firm makes profit If Price < ATC, the firm makes losses If Price = ATC, the firm earns zero profit (normal profit)
6 The market price is always $6. Quantity Total Revenue Total Cost Profit Marginal Revenue Marginal Cost 0 $
8 Review: Key Concepts for Competitive Markets Market price = MR and AR Profit maximization occurs where MR = MC If MR > MC, the firm should increase output If MR < MC, the firm should decrease output If where MR = MC is above ATC = firm makes profit If where MR = MC is below ATC = firm makes losses The MC curve is also the firms supply curve
16 Do you think economists would consider this a competitive market?
17 What are competitive markets? Main conditions that must be met: Many buyers and sellers Goods offered are identical or largely the same Consumers have complete control over price Firms can freely enter and exit the market
18 Economists sometimes call competitive markets perfect competition. So, whether you hear a firm is in a competitive market or in a perfectly competitive market, it is the same thing!
19 There are very few markets that compete perfectly The market for wheat is a competitive market. This is because there are many buyers and sellers of wheat AND all wheat is largely identical.
20 Most markets are not perfectly competitive, but very close. The burger market is close to perfectly competitive because there are many buyers and sellers, but the product they sell is NOT identical. So, these firms are monopolistically competitive.
21 Monopolistic Competition Firms that produce differentiated products. Products in a particular market that are slightly different than one another
22 We ll talk more about monopolistic competition in chapter 17!
23 So which market do you think buyers have more control over price?
24 The perfectly competitive firm
25 If Joe the farmer sells wheat for $5 a bushel, then I ll just go buy wheat from Bob instead who sells it for $4 a bushel. What do I care? All wheat is the same so I just want the cheapest price!
26 Price Takers Firms that are competing in a perfectly competitive market are the price takers. The firms have no control over price, so the only thing they can control is how much they produce. They must charge the market price
27 Nike has SOME control over the price of sweaters because they can offer a slightly different version than their competitors.
28 Joe the farmer has NO control over prices because his wheat is exactly the same as his competitors. So if he raises the price of his wheat, the customers will buy from his competitors instead. Therefore, Joe the farmer is a price taker.
29 Political Cartoon Contest Think of a market that is monopolistically competitive. (Products have some differences) Draw a political cartoon of what that market would look like if it was perfectly competitive. Make it unique and eye catching Creativity and humor definitely helps Using popular figures also helps dramatically The top three will be chosen by my best friends Then, the class will vote for the best cartoon in the class
31 Firms shut down vs. exit decision
32 Firm Activity Question? You run a drive in movie theater. In the month of November, if you stayed open it would cost you $150 to operate your theater. In that month, you would earn $100 in revenue. Your fixed cost is $100. How much profit/loss if you stayed open during November? How much profit/loss if you shut down during November? Shut Down= loss of $100 Stay Open = loss of $50 Because in the SHORT RUN there are still fixed costs to pay, it is rational to stay open in the short run because less money is lost.
33 What does shut down mean? Shutting down is a short-run decision not to produce anything for a specific period of time When firms decide to close down forever and leave the market, that is called an exit. Most golf courses shut down in the winter. In 2011, Borders exited the book market.
34 The Supply Curve (MC) for a Firm Short-Run Supply Curve The portion of its marginal cost curve that lies above average variable cost. Firm compares price to AVC Long-Run Supply Curve The marginal cost curve above the minimum point of its average total cost curve. Firm compares price to ATC
35 Costs and Revenue Long run supply curve starts here MC ATC AVC Quantity Short run supply curve starts here
36 Lets analyze a firm s cost and revenue graph to understand the shut down decision
37 At what market price(s) will this firm have guaranteed profit? Optimal P4 P3 Q3 Q4 Optimal P1 and P2
38 At what market price(s) will this firm have guaranteed losses? Optimal P4 P3 Q3 Q4 Optimal P3 and P4
39 If market price was at P4, should the firm shut down? Optimal P4 P3 Q3 Q4 Optimal NO!
40 Shutting Down If Price > or equal to AVC, the firm does not shut down If Price < AVC, the firm does shut down
41 At P4, the MR is greater than AVC. That means the quantity produced at P4 will cover all of the firm s variable costs plus some of its fixed costs. Optimal P4 P3 Q3 Q4 Optimal So, this is better than shutting down and having to pay all of the firm s fixed costs
42 If market price was P3, should the firm shut down? Optimal P4 P3 Q3 Q4 Optimal Yes!
43 At P3, the MR is less than AVC. That means the quantity produced at P3 will not cover all of the firm s variable costs. Optimal P4 P3 Q3 Q4 Optimal So, the firm won t be able to cover its variable costs and even its fixed costs. Shut down!
44 Review: Shut Down Key Concepts The short run supply curve is the portion of the MC curve that lies above AVC. The shut down decision only happens when a firm is comparing revenue to AVC. If Price > AVC, the firm does not shut down If Price < AVC, the firm does shut down
45 Questions? sh Optimal P4 P3 Q3 Q4 Optimal
46 The firms long run decision to exit the market
47 Remember, the long run supply curve starts at the MC curve above the minimum point of ATC curve Costs Long run supply curve starts here MC ATC Quantity So firms compare revenue to ATC when making long run decisions.
48 The rules of long run decisions When Price < ATC, the firm exits the market When Price > ATC, new firms enter the market
49 If market price was P1, the firm should exit the market because the revenue does not cover the total costs. Costs MC P3 ATC P2 P1 Q1 Q2 Q3 Quantity
50 If market price was P3, more firms will enter the market because the revenue not only covers the costs, but earns profit for the firm. Costs MC P3 ATC P2 P1 Q1 Q2 Q3 Quantity
51 What would happen if market price was P2? Costs MC P3 ATC P2 P1 Q1 Q2 Q3 Quantity
52 If market price was P2, no firms would exit or enter the market. This is because profits in this market have been driven to zero. Costs MC P3 ATC P2 P1 Q1 Q2 Q3 Quantity
53 Competitive Markets in the Long Run Oh, please be good to me invisible hand
54 Competitive Markets in the Long Run In the long run, Price = ATC Firms earn zero profit (normal). Firms will enter or exit the market until profit is driven to zero. The long-run market supply curve is perfectly elastic at this price (horizontal).
55 So lets look at Joe the farmer s competitive corn market
56 The beginning days the energy shot Market (a) Initial Condition Firm Price Price P 1 A Short-run supply, S 1 Long-run supply P 1 MC ATC Demand, D 1 0 Q 1 Quantity (market) 0 Quantity (firm) The corn market began in long run equilibrium And Joe s farm (the firm) earned zero profit.
57 Then, teens start to get hooked on corn An increase in market demand raises price and output. The higher P encourages firms to produce more and generates short-run profit. (b) Short-Run Response Market Firm Price Price P 2 P 1 A B S 1 P 2 D 1 D 2 Long-run supply P 1 MC ATC 0 Q 1 Q 2 Quantity (market) 0 Quantity (firm)
58 New firms enter the corn market Profits induce entry and market supply increases. Market (c) Long-Run Response Firm Price Price B S 1 MC ATC P 2 P 1 A C S 2 Long-run supply P 1 D 2 D1 0 Q 1 Q 2 Q 3 Quantity (market) 0 Quantity (firm) The increase in supply lowers market price. In the long run market price is restored, but market supply is greater.
59 We are now back on long run equilibrium In the short run, I made profit and produced more. But, in the long run, I m back to making zero profit (normal) and I even have more competitors!
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