11
CHAPTER
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Costs and Profit Maximization
Under Competition
1
CHAPTER OUTLINE
What Price to Set?
What Quantity to Produce?
Profits and the Average Cost Curve
Entry, Exit, and Shutdown Decisions
Entry, Exit, and Industry Supply Curves
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questions
2
Food for Thought….
Some good blogs and other sites to get the juices flowing:
3
The Big Questions
How do firms behave?
The assumption:
Profit is the main motivation for firms’
actions.
How do firms maximize profit?
By controlling their variables:
Price (if possible)
Quantity
Cost
Some firms have more control over prices than others.
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Competitive Firms
Let’s focus on one type of firm: the
Competitive Firm
Characteristics:
The product is similar across sellers
There are many buyers and sellers, each
small relative to the total market
Or
There are many potential sellers
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Competitive Markets Defined
• A Competitive Market operates under the
following conditions:
 There are many buyers and sellers;
 Goods produced are essentially the same;
 There are little or no barriers to entry and exit.
• These conditions imply that no single buyer or
seller has any influence on the market price and
that all firms must sell their output at the same
market price.
• Real world competitive markets: mostly
agricultural or commodity markets
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Competitive Markets Defined
• Firm’s must take the market price, have no influence
over price
• A price-taking firm’s actions, by definition, has a
negligible effect on market prices
• This means that a firm that sets its price above the
market price will sell zero quantity
• A firm that sets it price below market price is denying
itself revenues/profits (an opportunity cost) for no gain
• A competitive firm therefore faces a horizontal
(perfectly elastic) demand curve for its products
• However, the market demand curve still slopes
downward
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What Price to Set?
Competitive firms have no price control: The market determines
each firm’s price…
The Market for Oil
Price
Price
The Demand for Your Oil
Market
Supply
Demand for
Your Oil
$50
Market
Demand
82,000,000
Quantity
(barrels)
The demand for your oil is
perfectly elastic
Quantity
(barrels)
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Try it!
If you were a wheat farmer, what would happen if you
set your price above the other 1,000 farmers’ wheat
prices? Why wouldn’t you set your price below the
market price?
What kind (slope) of demand curve does this firm face?
How can a firm that produces oil face a very elastic
demand curve when the demand for oil is inelastic?
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Revenues and Profits Defined
• Total Revenue = P * Q = Price * Quantity sold
• We assume that the firm’s goal is to maximize profit.
• Economic profit is defined as:
Profit = Total revenue – Total cost
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Economic Costs Defined
•
•
•
•
•
•
Firms incur costs in the production process
Land, labor, capital costs
Accounting costs versus economic costs
Accounting costs do not include opportunity costs
Costs can be defined as either explicit and implicit
Economic costs are what matter most
•
•
•
Accounting costs = explicit costs
Economic costs = explicit + implicit costs
Difference is opportunity costs
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Explicit vs Implicit Costs
• Explicit costs – require an outlay of money,
e.g. paying wages to workers
• Implicit costs – do not require a cash outlay,
example) the opportunity cost of the owner’s time
• Opportunity Costs The cost of something is what you give up to get it.
• This is true whether the costs are implicit or explicit.
Both matter for firms’ decisions.
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Explicit vs Implicit Costs
Example:
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
 explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
 explicit cost = $3000 (5%) interest on the loan
 implicit cost = $2000 (5%) foregone interest you could have
earned on your $40,000.
• In both cases, total (exp + imp) costs are $5000.
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Explicit vs Implicit Costs
Example:
Assume the firm’s revenues are $10,000
What are the firm’s accounting and economic profits?
Accounting profits (explicit costs only):
Case 1: $10,000 - $5,000 = $5,000 profit
Case 2: $10,000 - $3,000 = $7,000
Economic profits (expl + impl costs):
Case 1: $10,000 - $5,000 = $5,000 profit
Case 2: $10,000 - $5,000 = $5,000
Accounting profits do not reflect implicit costs or
opportunity costs
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Economic versus Accounting Profits
BACK TO
Costs of Production
• Costs of production may be divided into two groups:
 Fixed Costs
 Variable Costs
• Economists pay very close attention to these concepts
in cost analysis
• A firm’s accounting data is very important in this
regard, being classified into fixed and variable costs
• Production costs made “at the margin” and sunk costs
(fixed costs) are ignored
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Costs of Production
• Total Costs can be broken down between fixed costs
and variable costs:
 TC = FC + VC
 Fixed costs are those costs incurred when output (Q) is zero
• Consists of factors of production that are fixed for the short run, i.e.
land, buildings, machinery, insurance, etc
• Fixed costs do not vary with output
• The firm faces fixed costs no matter what
 Variable costs are those costs that vary with output (Q)
• Labor costs, materials costs, energy costs, etc
• Variable costs equal zero when output is zero
• As output increases, variable costs increase
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Costs of Production
• Example: Airline Costs
• What is the airline’s product (Q)?
 Passenger miles
 Note: Revenues = Price * Q
• Fixed costs – airplanes, buildings, maintenance
facilities, land, insurance, etc
• Variable costs - aviation fuel, pilot costs, other
expenses related to actually flying the planes,
producing passenger miles
 To spread fixed costs, must keep airplanes in the air
as much as possible (Southwest)
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Costs of Production
• Transform costs into average cost per Q:
 TC = FC + VC becomes
 TC/Q = FC/Q + VC/Q yields
 ATC = AFC + AVC
 where
 ATC = TC/Q
 AFC = FC/Q
 AVC = VC/Q
 Note that Cowan/Tabarrok text labels ATC as AC
• The average cost format allows a much easier to interpret
graphical representation of a firm’s cost structure and the
profit maximization conditions
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Costs of Production
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Average Fixed Cost
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Average Variable Cost
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Average Total Cost
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Average Total Cost
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Marginal Cost
• Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q
• Where ∆ means the difference or “change in”
• MC = (Change in TC)/(Change in output)
• i.e. [(TC @ Q1000) – (TC @ Q999)]/(1000-999)
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Marginal Cost
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Marginal Cost
• Why does marginal cost rise so rapidly at higher levels
of output?
• Due to decreasing “marginal product” as per the
production function (not covered in this text)
• Marginal product (MP) is covered in Chapter 14
• Suffice to say, that as production increases, each
additional unit of input causes output to rise at a
decreasing rate (MP could be zero at some point)
• i.e. while input costs rise, less output results
• This causes the MC of an additional unit of output to
eventually rise
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Costs of Production
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Profits
 Profits and losses are a necessary and integral part of
a market economy
 Can be thought of as a residual against revenues
once all costs (including opportunity costs) are paid
 Profits are returns to equity owners of a firm
 Profits are viewed as “evil” by many, mostly
economically illiterate people
 Yet, profits/losses exist in any type of economy, from
Cuba to N. Korea to Singapore to England to Russia,
whether they realize it or not
 Profits and losses are absolutely necessary for an
economy to be efficient
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Profits
 Profits are signals to entrepreneurs or owners as to
the viability of their investments and their skill as
owners/managers
 What if “too much “ profit is being earned?
Competition, if allowed, will reduce the excess to
“normal” levels
 Early economists, not just Karl Marx, thought that all
profits should go to labor (“Labor Theory of Value”),
not the owners of capital, hence Marx coined the term
Capitalism
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Profits
 Profits indicate a willingness of consumers to pay a
price higher than the (opportunity) costs incurred by
producers
 Losses indicate that producers should allocate their
resources elsewhere in hopes of receiving revenues
that will cover their costs (including opportunity costs)
 In a market system, profits are the signal to producers
or new firms to increase output to gain economic
returns
 In competitive markets, higher than normal profit
levels will attract new firms, eventually causing prices
and revenues to fall
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Profits
 Losses are equally important signals, telling
firms/entrepreneurs that society does not value their
product sufficiently to cover the opportunity costs of
production
 Firms must be allowed to fail in order to “educate”
themselves and the market, so as to allocate scarce
resources to their highest valued use
 If not, overall economic efficiency is decreased and
society becomes poorer as a result
 Implication: wherever possible, promote competitive
markets rather than enacting “windfall” profit taxes or
government regulation
 No surprise - business owners hate competition
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Maximizing Profit
Firms look for ways to maximize profit
Profit =
p = Total Revenue – Total Cost
Profit is calculated as the difference between
total revenue and total cost.
Profit = Total Revenue – Total Cost = TR – TC
Total Revenue is price times quantity sold: TR = P x Q.
Total Cost is the cost of producing a given quantity of
output.
Remember ATC = TC/Q, so TC = ATC * Q
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Maximizing Profit
Substituting:
Profit = (P * Q) – (ATC * Q) rearranging terms yields:
Profit = Q * (P – ATC)  most useful form of profit
equation
When P >ATC  profits are positive
when P < ATC  losses occur (profits < 0)
and if P = ATC  profits are zero
Since a firm in a competitive market must sell its
output at the market price, profit maximization
depends only on the firm’s output decision
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The Profit-Maximizing Quantity
Each time the firm produces another unit
there are extra costs and extra revenues.
Profit-maximization is about comparing the
extra revenues to the extra costs at the
margin.
Marginal Revenue (MR) = the change in total
revenue from selling an additional unit of
output.
Marginal Cost (MC) = the change in total cost
from producing an additional unit of output.
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The Profit-Maximizing Quantity
What quantity maximizes p?
p is maximized by producing where MR =
MC.
Why?
Because if MR > MC, producing more will add to
your profit.
And if MR < MC, producing less will add to your
profit.
Since MR = P for competitive firms, the profitmaximizing rule becomes produce where
P = MC.
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The Shape of MR and MC
MC risesMR
with
because
gets more
costly we
to produce
each
is production
constant because
no itmatter
how much
sell, the next
additional
e.g. more
equipment,
more
maintenance, etc.
unitunit…
will always
sell for
the market
price.
Profit is Maximized Where P = MC
Price
150
MC
100
50
MR = P
Quantity
0
1
2
3
4
5
6
7
8
9
10
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Maximizing Profit
• To maximize profit a competitive firm will expand
production until the revenue from an additional sale
equals the cost of an additional sale.
 If marginal revenue is greater than marginal cost (MR > MC),
then an additional unit of output increases revenues more
than costs leading to greater profit.
 If marginal revenue is less than marginal cost (MR < MC),
then an additional unit of output increases costs more than
revenues leading to less profit.
 So, profit is maximized at a level of output where MR = MC.
 If MC > MR (P) then reduce Q to increase profits
 If MR (P) > MC then increase Q to increase profits
BACK TO
If Market Price Changes, So Does ProfitMaximizing Quantity
Price
MC
$100
MR = P
$50
MR = P
Quantity
0
1
2
3
4
5
6
7
8
9
10
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Profits and the Average Cost Curve
We now know how to find the profitmaximizing quantity, now it’s time to ask:
What is the size of the profit?
Average Cost of Production = the total cost of
producing Q units of output divided by Q
AC 
Total Cost
Q

Fixed Cost  Variable Cost 

Q
BACK TO
Profits and the Average Cost Curve
Quantity
MR =
Price
0
$0
1
Change in
Profit
Average
Cost
TC
Profit
MC
0
30
-$30
0
$0
0
$50
50
34
$16
4
$46
34.0
2
$50
100
40
$60
6
$44
20.0
3
$50
150
51
$99
11
$39
17.0
4
$50
200
68
$132
17
$33
17.0
5
$50
250
91
$159
23
$27
18.2
6
$50
300
120
$180
29
$21
20.0
7
$50
350
156
$194
36
$14
22.29
8
$50
400
206
$194
50
$0
25.75
9
10
TR
Maximum profit is here
$50
450
296
$154
90
-$40
32.89
$50
500
420
$80
124
-$74
42.0
41
BACK TO
Calculating Profits
Since AC = (TC/Q) we can rearrange to find TC = AC x Q
We know that p = TR – TC, and TR = (P x Q), so substituting in the TC
equation gives us:
p = (P – AC) x Q
Price
MC
$50
P
Profit = $194 = ($50- $25.75) X 8
MR = P
Average Cost (AC)
$25.75
AC
$17
Quantity
0
1
2
3
4
5
6
7
8
9
10
BACK TO
Try it!
If a firm is earning positive economic
profit, it must be the case that
a)
b)
c)
d)
price
price
price
price
cost.
is
is
is
is
less than average cost.
equal to average cost.
equal to total cost.
greater than average
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Ralph opened a small shop selling bags of trail
mix. The price of the mix is $5, and the market
for trail mix is very competitive. At what
quantity will Ralph produce?
a) 7
b) 10
c) 14
d) 18
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Ralph opened a small shop selling bags of trail
mix. When the price is $5, how much profit will
Ralph make?
a) $0
b) $14
c) $52
d) $68
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Marginal and
Average Cost Curve
The MC curve intersects the AC curve at its
minimum point.
When marginal cost is just below average cost, the AC
curve is falling.
When marginal cost is just above average cost, the
AC curve is rising.
So, AC and MC curves must meet at the minimum of
the AC curve.
BACK TO
When to Enter and Exit
an Industry
In competitive markets a firm will be
profitable when P > AC and unprofitable
when P < AC.
So, in the long run, firms will enter
profitable industries (P > AC ) and will exit
unprofitable ones (P < AC).
Note that at the intermediate point (P =
AC) profits are zero, and there is no entry
or exit.
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Zero Profits
Economists refer to Zero Profits or “normal”
profits as the profit level where the firm is
covering all of its costs including enough to
pay labor and capital their opportunity costs.
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“Economic” vs. “Accounting” Profit
Remember, not all costs require monetary
payment!
An explicit cost is a cost that requires a
money outlay.
An implicit cost is a cost that does not
requires an outlay of money.
Economic profit is total revenue minus
total costs including implicit costs.
Accounting profit is total revenue minus
explicit costs.
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BACK TO
Zero Profits
Example: if you quit your job as a lion tamer
($45,000/year income) to open a tanning studio
($45,000/year left over after costs are paid), what
is your economic profit?
We would say it’s zero: you are earning just enough to
cover your costs, including your foregone lion taming
wages.
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Try it!
Imagine that Alex and Tyler each decide to drill an
oil well in their backyard, which costs $200,000.
Alex borrows the $200,000 from a bank at a 5%
annual rate of interest so Alex must pay the bank
$10,000 per year ($10,000 = 0.05 × $200,000).
Tyler pays the $200,000 out of a small inheritance
he received from a rich uncle. Each well produces
$15,000 worth of oil annually.
Which well is more profitable (Economic profit)?
a) Alex
b) Tyler
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c) They are equally profitable
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Zero Profits
Other examples of implicit costs include
foregone rent (if you are using your own
property as the tanning studio), foregone
interest income (if you use your own life
savings as the start-up money) and many
others.
Firms will need to consider these costs if they
want to make good decisions.
From now on, we’ll assume that our cost curves
take these opportunity costs into account.
And therefore a zero profit isn’t a bad thing!
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Entry and Exit with
Uncertainty and Sunk Costs
If P < AC, the firm will exit the industry in
the long-run, but what about the shortrun?
Will the firm shutdown immediately if price
dips below average cost?
Not necessarily!
BACK TO
Entry and Exit with
Uncertainty and Sunk Costs
The firm may be earning enough revenue to
pay some of its costs
If it shuts down it will still have to pay its fixed
costs (which may be less than its revenue). Even
though it’s losing money, It may have enough to
cover its variable costs and a portion of its fixed
Fortune cookie equipment
costs.
costs money
There may be extra costs to
shut down (severance
pay, etc.).
54
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Entry and Exit with
Uncertainty and Sunk Costs
A firm should stay open in the short run if it can cover its variable costs
Decision
Fixed Costs
Variable Costs
Revenue
Profit
Shutdown
$100
0
0
-$100
Stay Open
$100
$50
$75
-$75
He’ll stay in business… for now.
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Entry and Exit with
Uncertainty and Sunk Costs
Sunk Cost = a cost that once incurred can
never be recovered.
If it closes down, this oil company
won’t recover the cost of this rig.
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Entry and Exit with
Uncertainty and Sunk Costs
If a firm could instantly and costlessly enter
and exit an industry, then this basic rule
applies: enter when P > AC and exit when
P < AC.
But, when it is costly to enter and exit and
there is uncertainty about future prices, firms
must make their decisions based on their
lifetime expected profit.
Note: this estimation can be quite difficult to
make, and any error could lead to significant
losses.
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Deriving Industry Supply Curves
The industry supply curve is built from the MC
curves and the entry and exit decisions of
firms.
A firm will enter when P > AC and will expand
production along its MC curve when price rises
above this level.
Thus, a firm’s supply curve is the portion of the
MC curve above the AC curve.
BACK TO
Deriving Industry Supply Curves
Price
Price
MC1
MC2
AC2
$50
AC1
$29
$17 $
0 1
2
3
4
5
6
7
8
9
10
Firm 1
Quantity
0 1
2
3
4
5
6
7
Firm 2
$50
S
8
9
10
Quantity
S
Quantity Supplied by the Industry is the Sum of the Quantities Supplied
by Each Firm at Every Price
$29
$17
0 1
q
2
3
4
5
6
7
8
9
10 11 12 13 14 15 16 17
BACK TO
Deriving Industry Supply Curves
The shape of the supply curve for a particular
industry is determined by the change in costs as
industry output increases or decreases.
There are three types of industry supply curves.
1. Increasing Cost Industry = an industry in which costs
increase with greater output; shown with an upward
sloping supply curve.
2. Constant Cost Industry = an industry in which costs do
not change with greater output; shown with a flat
supply curve.
3. Decreasing Cost Industry = an industry in which
industry costs decrease with greater output; shown
with a downward sloping supply curve.
BACK TO
Increasing, Constant, and
Decreasing Cost Industries
Price
Supply, Increasing Cost Industry
Supply, Constant Cost Industry
Supply, Decreasing Cost Industry
Demand
Quantity
BACK TO
Constant Cost Industries
Constant cost industries capture two
important aspects of competitive markets:
1. Price is quickly driven down to the
average cost of production;
2. Firms earn zero (or normal) profit.
This does not mean that firms are just breaking
even.
Remember, the costs of production include the
opportunity costs of the inputs used in production.
This implies that firms are earning a rate of profit
equal to that of any other use of those inputs.
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How a Constant Cost Industry Adjusts to an
Increase in Demand
An increase in demand
causes prices to rise…
Which increases profits and
attracts new firms…
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How a Constant Cost Industry Adjusts to an
Increase in Demand
And Profits are driven back
down.
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Short and Long Run
The Short Run = the time period before
entry occurs.
The Long Run = the time it takes for
substantial new investment and entry to
occur.
BACK TO
Try it!
How long is the “long run”? It will vary
from industry to industry. How long
would you estimate the long run is in
the market for electrical engineers?
a) 2-3 days
b) 2-3 months
c) 2-3 years
d) More than 2-3 years
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Increasing Cost Industries
As a firm expands production when price
rises, the firm will require more inputs.
Because these resources are limited, their
prices will rise- driving up production costs.
An Increasing Cost Industry is an industry
characterized by greater costs as production
expands.
As oil production increases, we tap into highercost oil sources as extraction costs rise.
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Decreasing Cost Industries
A Decreasing Cost Industry is an industry
characterized by lower costs as
production expands.
industry clusters help reduce costs as
production increases
More specialized resources in one place improve
each other’s efficiency
Dalton, Georgia: carpet capital of the world
Hollywood, CA, USA: movie capital of the world
Silicon Valley, California: a high-tech cluster
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Try it!
In the competitive electrical motor industry, the
workers at Galt Inc. threaten to go on strike. In order
to avoid the strike, Galt Inc. agrees to pay its workers
more. At all other factories, the wage remains the
same. What will happen to the number of motors
produced by Galt Inc.?
a)
b)
c)
d)
The number of motors produced will rise.
The number of motors produced will remain the
same.
The number of motors produced will fall.
This cannot be determined without more
information.
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