ECON_2306 => Lecture 7A Slides

ECON_2306 => Lecture 7A Slides - Pricing and Output...

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Unformatted text preview: Pricing and Output Decisions in Perfect Competition The The Basic Business Decision: entering a market on the basis of the the following questions: How much should we produce? If we produce such an amount, how much profit will we earn? If loss rather than profit is incurred will it be worthwhile to If a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that we will eventually eventually earn a profit) or should we exit? L7A: L7A: Pure/Perfect Competition (Chapter 9) Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 Pricing and Output Decisions in Perfect Competition Key assumptions of the perfectly competitive market The The firm operates in a perfectly competitive market and therefore therefore is a price taker. The The firm makes the distinction between the short run and the long long run. The firm’s objective is to maximize its profit in the short run. If The it cannot earn a profit, then it seeks to minimize its loss. The The firm includes its opportunity cost of operating in a particular market market as part of its total cost of production. Pricing and Output Decisions in Perfect Competition Perfectly Perfectly Elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the the going market price. Fi Firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price price of the product. No No limit to the total revenue that the firm can gain in a perfectly competitive market. market. Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 1 Preview of the Four Market Structures Perfect Competition Perfectly competitive market A market with many sellers and buyers of a homogeneous product and no barriers to entry. Price taker Price taker A buyer or seller that takes the market price as given. a. Pure competition entails a large number of firms, standardized product, and easy entry (or exit) by new (or existing) firms. b. At the opposite extreme, pure monopoly has one firm that is the sole seller of a product or service with no close substitutes; entry is blocked for other firms. c. Monopolistic competition is close to pure competition, except that the product is differentiated among sellers rather than standardized, and there are fewer firms. d. An oligopoly is an industry in which only a few firms exist, so each is affected by the price-output decisions of its rivals. Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 Perfect Competition Here are the five features of a perfectly competitive market: 1. There are many sellers. 2. There are many buyers. 3. The product is homogeneous. 4. There are no barriers to market entry. 5. Both buyers and sellers are price takers. Preview of the Four Market Structures Firm-specific demand curve A curve showing the relationship between the price charged by a specific firm and the quantity the firm can sell. Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 2 Monopoly Versus Perfect Competition Monopoly Versus Perfect Competition Definitions of average, total, and marginal revenue. 1. Average revenue is the price per unit for each firm in pure competition. 2. Total revenue is the price multiplied by the quantity sold. 3. Marginal revenue is the change in total revenue and will also equal the unit price in conditions of pure competition. Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 How a Firm Maximizes Profit in a Perfectly Perfectly Competitive Market Average revenue (AR) Total revenue divided by the number number of units sold. AR TR Q Profit = (P x Q) Profit Q ( P Q) Q TC TC TC Q so, AR TR Q PQ Q P Or Marginal revenue (MR) Change in total revenue from selling selling one more unit. Marginal Revenue Change in total revenue , or MR Change in quantity TR Q Profit Q P ATC , Profit Profit = (P ATC ATC)Q Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 3 Demand as Seen by a Purely Competitive Seller Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) Demand as Seen by a Purely Competitive Seller Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) $131 0 $ 0 $131 131 0 1 $ 0 ] 131 $131 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 Demand as Seen by a Purely Competitive Seller Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) Demand as Seen by a Purely Competitive Seller Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) $131 131 131 0 1 2 $ 0 ] 131 ] 262 $131 131 $131 131 131 131 0 1 2 3 $ 0 ] 131 ] 262 ] 393 $131 131 131 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 4 DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) $131 131 131 131 131 0 1 2 3 4 $ 0 ] 131 ] 262 ] 393 ] 524 $131 131 131 131 Principles of Microeconomics, SP 2010 0 $131 1 131 2 131 3 131 4 131 5 131 6 131 7 131 8 131 9 131 10 131 Principles of Microeconomics, SP 2010 $ 0 ] 131 ] 262 ] 393 ] 524 ] 655 ] 786 ] 917 ] 1048 ] 1179 ] 1310 $131 131 131 131 131 131 131 131 131 131 DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) Quantity Total (Average Revenue) Demanded (Q) Revenue (TR) Marginal Revenue (MR) DEMAND, MARGINAL REVENUE, AND TOTAL REVENUE IN PURE COMPETITION 1179 1048 TR $131 0 131 1 131 2 3 131 4 131 5 131 6 131 7 131 8 131 9 131 10 SP 2010 131 Principles of Microeconomics, Price and revenue $ Graphically Presented… 0 ] 131 ] 262 ] 393 ] 524 ] 655 ] 786 ] 917 ] 1048 ] 1179 ] 1310 $131 131 131 131 131 131 131 131 131 131 917 786 655 524 393 262 131 0 1 2 3 4 5 6 7 8 D = MR 9 10 Principles of Microeconomics, SP 2010 Quantity Demanded (sold) 5 SHORT RUN PROFIT MAXIMIZATION Total Revenue-Total Cost approach: RevenueCompare Compare the total revenue and total cost schedules and find the level of output that either maximizes the firm’s profits or or minimizes its loss. Marginal Revenue – Marginal Cost Approach Mar A firm that wants to maximize its profit (or minimize its firm loss) should produce a level of output at which the additional revenue received from the last unit is equal to the additional additional cost of producing that unit. In short, MR=MC. For For the perfectly competitive firm, the MR=MC rule may be be restated as P=MC. This is because P=MR in perfectly competitive markets. Principles of Microeconomics, SP 2010 Pricing and Output Decisions in Perfect Competition The The point where P=MR=MC is the optimal output output (Q*) Profit Profit = TR – TC =(P AC) Q* =(P - AC) · Q* Principles of Microeconomics, SP 2010 Pricing and Output Decisions in Perfect Competition The The firm incurs a loss. At the optimum output level price is below below average cost. However, However, since price is greater than average variable cost, the firm is better off producing in the short run, because it will still it incur fixed costs greater than the loss. loss. Pricing and Output Decisions in Perfect Competition Contribution Contribution Margin (CM): the amount by which total revenue exceeds total variable variable cost. CM CM = TR – TVC If the contribution margin is If the contribution margin is positive, the firm should continue to produce in the short run in order to defray some some of the fixed cost. Shutdown Shutdown point: The point where the price is equal to the minimum point on the AVC. AVC. Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 6 Pricing and Output Decisions in Perfect Competition Shutdown Shutdown Point: the lowest price at which the firm would still produce. produce. At At the shutdown point, the price is equal to the minimum point on the AVC. This is where selling at the price results in zero contribution contribution margin. If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be be better off if it shut down and just paid its fixed costs. SHORT RUN PROFIT MAXIMIZATION 1. Total-Revenue -Total Cost Approach A. In the short run the firm has a fixed plant and maximizes profits or minimizes losses by adjusting output; profits are defined as the difference between costs and total revenue total costs and total revenue. B. Three questions must be answered. 1. Should the firm produce? 2. If so, how much? 3. What will be the profit or loss? Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 TOTAL REVENUE-TOTAL COST APPROACH SHORT RUN PROFIT MAXIMIZATION 1. Total-Revenue -Total Cost Approach C. An example of the total-revenue—total-cost approach is shown below. 1. The firm should produce if the difference between total revenue and total cost is profitable, or if the loss is less than the fixed cost. 2. In the short run, the firm should produce that output at which it maximizes its profit or minimizes its loss. 3. The profit or loss can be established by subtracting total cost from total revenue at each output level. 4. The firm should shut down in the short run if its loss exceeds its fixed costs. Then, by shutting down its loss will just equal those fixed costs. Total Total Total Fixed Variable Total Product Cost Cost Cost 0 1 2 3 4 5 6 7 8 9 10 $ 100 $ 0 $ 100 100 90 190 100 170 270 100 240 340 100 300 400 100 370 470 100 450 550 100 540 640 100 650 750 100 780 880 100 930 SP 2010 1030 Principles of Microeconomics, Total Revenue Profit $ 0 131 262 393 524 655 786 917 1048 1179 1310 Price: $131 - $100 - 59 -8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280 A graphical representation is shown below. Note: The firm has no control over the market price. Principles of Microeconomics, SP 2010 7 TOTAL REVENUE-TOTAL COST APPROACH TOTAL REVENUE-TOTAL COST APPROACH $1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 0 0 1 2 3 4 5 6 7 8 9 10 $ 100 $ 0 $ 100 100 90 190 100 170 270 100 240 340 100 300 400 100 370 470 100 450 550 100 540 640 100 650 750 100 780 880 100 930 1030 Principles of Microeconomics, SP 2010 $ 0 131 262 393 524 655 786 917 1048 1179 1310 - $100 - 59 -8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280 Total revenue and total cost Total Total Total Fixed Variable Total Product Cost Cost Cost Total Revenue Profit Price: $131 Break-Even Point (Normal Profit) Total Revenue Maximum Economic Profits $299 Total Cost Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Principles of Microeconomics, SP 2010 THE FIRM’S SHORT-RUN OUTPUT SHORT-RUN DECISION DECISION The The Total Approach: Computing Total Revenue and Total Total Cost THE THE FIRM’S SHORT-RUN OUTPUT SHORT-RUN DECISION DECISION Using the Total Approach to Choose an Output Level The The Total Approach: Computing Total Revenue and Total Total Cost Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 8 THE FIRM’S SHORT-RUN OUTPUT SHORT-RUN DECISION DECISION 2. The Marginal Approach The Marginal-Revenue -Marginal Cost Approach Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost. • marginal revenue The change in total revenue from selling one more unit of output. marginal revenue = price To maximize profit, produce the quantity where price = marginal cost Principles of Microeconomics, SP 2010 SHORT RUN PROFIT MAXIMIZATION 2. Marginal-Revenue -Marginal Cost Approach A. The MR = MC rule states that the firm will maximize profits or minimize losses by producing at the point at which marginal revenue equals marginal cost in the short run. B. Three features of this MR = MC rule are important. The rule assumes that marginal revenue must be equal to or exceed The rule assumes that marginal revenue must be equal to or exceed minimum-average-variable cost or firm will shut down. The rule works for firms in any type of industry, not just pure competition. In pure competition, price = marginal revenue, so in purely competitive industries the rule can be restated as the firm should produce that output where P = MC, because P = MR. Principles of Microeconomics, SP 2010 MARGINAL REVENUE-MARGINAL COST APPROACH MARGINAL REVENUE-MARGINAL COST APPROACH Price: $131 TR $ Total Total Fixed Cost Product Cost Average Average Average Price = Total Variable Total Marginal Marginal Economic Cost Cost Cost Revenue Profit/Loss $ 131 131 131 131 131 131 131 131 131 131 - $100 - 59 -8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280 Average Average Average Price = Total Total Fixed Variable Total Marginal Marginal Economic Cost Cost Product Cost Cost Revenue Profit/Loss 0 1 2 3 4 5 6 7 8 9 10 $100.00 $90.00 $190.00 90 50.00 85.00 135.00 80 33.33 80.00 113.33 70 25.00 75.00 100.00 60 94.00 70 20.00 74.00 91.67 80 16.67 75.00 91.43 90 14.29 77.14 93.75 110 12.50 81.25 97.78 130 11.11 86.67 10.00 93.00 103.00 150 Principles of Microeconomics, SP 2010 0 100 0 131 190 1 262 270 2 393 340 3 524 400 4 655 470 5 786 550 6 917 640 7 1048 750 8 1179 880 9 1310 1030 10 $100.00 $90.00 $190.00 90 50.00 85.00 135.00 80 33.33 80.00 113.33 70 25.00 75.00 100.00 60 94.00 70 20.00 74.00 91.67 80 16.67 75.00 91.43 90 14.29 77.14 93.75 110 12.50 81.25 97.78 130 11.11 86.67 10.00 93.00 103.00 150 Principles of Microeconomics, SP 2010 $ 131 131 131 131 131 131 131 131 131 131 - $100 - 59 -8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280 9 MARGINAL REVENUE-MARGINAL COST APPROACH MARGINAL REVENUE-MARGINAL COST APPROACH The level of profit can be found by multiplying ATC by the quantity, 9, which is $880 (9*97.78), and subtracting that from total revenue, which is $131 x 9 or $1179. Profit will be $299 (1179-880)when the price is $131. Profit Maximization Position Cost and Revenue Compare MC and MR at each level of output. At the 10th unit MC exceeds MR. Therefore, the firm should produce only nine (not the tenth) units to maximize profits. Profit Maximization Position $200 $200 150 100 50 0 Cost and Revenue Economic Profit MC MR ATC AVC Economic Profit 150 100 50 0 MC MR ATC AVC $131.00 $97.78 $131.00 $97.78 Principles of Microeconomics, SP 2010 1 2 3 4 5 6 7 8 9 10 Profit per unit could also have been found by subtracting $97.78 from $131 and then multiplying by 9 to get $299. Principles of Microeconomics, SP 2010 1 2 3 4 5 6 7 8 9 10 MARGINAL REVENUE-MARGINAL COST APPROACH MARGINAL REVENUE-MARGINAL COST APPROACH Loss-minimizing case: The loss-minimizing case is illustrated when the price falls to $81. Marginal revenue does exceed average variable cost at some levels, so the firm should not shut down. Comparing P and MC, the rule tells us to select an output level of 6. At this level the loss of $64 is the minimum loss this firm could realize, and the MR of $81 just covers the MC of $80, which does not happen at a quantity level of 7. Loss Minimization Position Loss Minimization Position $200 Cost and Revenue If the price is lowered from $131 to $81… the MR=MC rule still applies MR Economic Loss 150 100 50 0 MC …but the MR = MC point changes. Principles of Microeconomics, SP 2010 $91.67 $81.00 ATC AVC MR Principles of Microeconomics, SP 2010 1 2 3 4 5 6 7 8 9 10 10 MARGINAL REVENUE-MARGINAL COST APPROACH Short-Run Shut Down Point Cost and Revenue Shut-down case: If the price falls to $71, this firm should not produce. MR will not cover AVC at any output AVC at any output level. Therefore, the minimum loss is the fixed cost and production of zero. The $100 fixed cost is the minimum possible loss. $200 The Shut-Down Price ShutMC THE FIRM’S SHUT-DOWN SHUT-DOWN DECISION DECISION 150 100 $71.00 operate if price > average variable cost shut down if price < average variable cost ATC AVC MR Minimum AVC is the Shut-Down Point 1 2 3 4 5 6 7 8 9 10 50 • shut-down price The price at which the firm is indifferent between operating and shutting down; equal to the minimum average variable cost. 0 Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 SHORTSHORT-RUN SUPPLY CURVES The Firm’s Short-Run Supply Curve Short• short-run supply curve A curve showing the relationship between the market price of a product and the quantity of output supplied by a firm in the short run. fi th Illustrating Profit or Loss on the Cost Curve Graph P > ATC, which means the firm makes a profit which P = ATC, which means the firm breaks even (its total cost equals it total revenue) ATC breaks (its P < ATC, which means the firm experiences losses which Principles of Microeconomics, SP 2010 Principles of Microeconomics, SP 2010 11 Marginal cost and the short-run supply curve can be illustrated by hypothetical prices. At a price of $151 profit will be $480; at $111 the profit will be $138 ($888-$750); at $91 the loss will be $3.01; at $61 the loss will be $100 because the latter represents the close-down case. Assume that EQ=8 (Equilibrium quantity) per firm and EP=111 (Equilibrium Price). Marginal Cost & Short-Run Supply Marginal Cost & Short-Run Supply Note Note that the table gives us the quantities that will be supplied at several different price levels in the shortshort-run. Since a short-run supply schedule tells how much short-run quantity will be offered at various prices, this identity of of marginal revenue with the marginal cost tells us that the marginal cost above AVC will be the shortshort-run supply for this firm (see the Figure). Price Quantity Supplied Maximum Profit (+) Or Minimum Loss (-) $151 $151 10 131 9 111 8 91 7 81 6 71 0 61 of Microeconomics, SP 2010 0 Principles $+480 +299 +138 -3 -64 -100 -100 Principles of Microeconomics, SP 2010 Cost and Revenue, (dollars) MC Cost and Revenue, (dollars) Shutdown point: The minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short run. MARGINAL REVENUE-MARGINAL COST APPROACH MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Break-even (Normal Profit) Point P5 Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve MC Supply MR5 MR4 MR3 MR2 MR1 MR5 ATC P5 P4 P3 P2 P1 AVC MR4 MR3 MR2 MR1 P4 P3 P2 P1 Do not Produce – Below AVC Q2 Q3 Q4 Q5 No Production Below AVC Q2 Q3 Q4 Q5 Principles of Microeconomics, SP 2010 Quantity Supplied Principles of Microeconomics, SP 2010 Quantity Supplied 12 Cost and Revenue, (dollars) Cost and Revenue, (dollars) Changes in prices of variable inputs or in technology will shift the marginal cost or short-run supply curve 1. A wage increase would shift the supply curve upward. 2. Using this logic, a specific tax would cause a decrease in the supply curve (upward shift in MC). Marginal Cost & Short-Run Supply MC2 S2 MC1 S1 AVC2 AVC1 MARGINAL REVENUE-MARGINAL COST APPROACH MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Lower Costs Move the Supply Curve to the Right MC1 S1 MC2 S2 AVC1 AVC2 Technological progress would shift the marginal cost curve downward. Using this logic a unit subsidy would cause an increase in the supply curve (downward shift in MC). Higher Costs Move the Supply Curve to the Left Principles of Microeconomics, SP 2010 Quantity Supplied Principles of Microeconomics, SP 2010 Quantity Supplied Individual firm supply curves are summed horizontally to get the totalsupply curve S. If product price is $111, industry supply will be 8000 units, since that is the quantity demanded and supplied at $111. This will result in economic profits SHORT-RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” its Price from the Industry Equilibrium P Economic ATC Profit S=MC...
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