Ch 11 - Competition(2) - Ch 11 Costs and Profit Maximization Under Competition 1 Overview In a competitive market firms maximize profits by choosing

Ch 11 - Competition(2) - Ch 11 Costs and Profit...

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Ch. 11 Costs and Profit Maximization Under Competition 1
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Overview In a competitive market, firms maximize profits by choosing output such that MR = P = MC. If price falls below AC, firms shut down and exit an industry. In the long run, firms will enter or exit an industry until π = 0. 2
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Theory of the Firm Pricing, output, entry, and exit decisions by a firm in a competitive industry “Perfect competition” No barriers to entry or exit of firms Firms and buyers are small relative to the market (price-takers). The product is similar/identical across sellers. 3
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Key assumption In competitive industries, there are many producers and consumers. As a result, the market sets the price and each producer or buyer is a price-taker. 4
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Farmer Jones is a “price-taker”. He faces a perfectly elastic demand curve for his corn. P Q D Jones $3/bu He can sell all he wants at the current market price of $3/bu. 5
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$3/bu D Jones P Q Thousands bu Q Millions bu P $3/bu S D World Farmer Jones Farmer Jones is a price-taker on the supply side. Farmer Jones can sell all he wants at the world price $3. 6
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$3/bu S ME P Q Thousands bu Q Millions bu P $3/bu S D World Mother Earth Bakery Mother Earth Bakery is a price-taker on the demand side. Mother Earth can buy all she wants at the world price $3. 7
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For a firm in a competitive industry, price is given. Profit maximization involves choosing Q to maximize profits. π = Profits = Total Revenue – Total Costs Total Revenue = TR = P x Q Total Cost = TC(Q) (a function of Q) 8
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An important distinction Total Cost (TC) includes the opportunity cost of all resources used. Explicit costs (things that must be paid for) Implicit costs (things that do not require an outlay of money) 9
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Examples Small business, self-employed You own a building. Impute rent You are self-employed. Impute alternative earnings Key: Cost = Opportunity Cost Best alternative use of resources 10
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Profit is π = Profit = Total Revenue – Total Costs This is Economic Profit.
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