PURE COMPETITION PURE COMPETITION Many small firms Standardized product No need to advertise “Price takers” Free entry and exit Perfectly elastic demand Average revenue Marginal revenue Price 9-2 Demand for Perfectly Competitive Firms Why are they Price Takers? •If a firm charges above the market price, NO ONE will buy. They will go to other firms •There is no reason to price low because consumers will buy just as much at the market price. Since the price is the same at all quantities demanded, the demand curve for each firm is… Perfectly Elastic (A Horizontal straight line) Copyright ACDC Leadership 2015 3 The Competitive Firm is a Price Taker Price is set by the Industry Industry (all firms) P Firm S P $10 $10 Demand D 5000 Copyright ACDC Leadership 2015 Q Q 4 The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an additional unit? 1st unit earns $10 2nd unit earns $10 Marginal revenue is constant at $10 Notice: Firm P $10 • Total revenue increases at a constant rate • MR equal Average Revenue Copyright ACDC Leadership 2015 Demand MR=D=AR=P Q 5 The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an Firm additional unit? Competition: P For Perfect 1st unit earns $10 = MR 2nd unit earnsDemand $10 Marginal revenue is (Marginal Revenue) constant at $10 Demand $10 Notice: MR=D=AR=P • Total revenue increases at a constant rate • MR equal Average Revenue Copyright ACDC Leadership 2015 Q 6 Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! •To maximum profit firms must make the right output •Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) • Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 Copyright ACDC Leadership 2015 7 Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! •To maximum profit firms must make the right output •Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) • Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 Profit Maximizing Rule MR=MC Copyright ACDC Leadership 2015 8 Lets put costs and revenue together to calculate profit. Firm Industry P S P (price taker) MC $7 $7 Demand ATC D Copyright ACDC Leadership 2015 10,000 Q Q 9 •How much output should be produced? •How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much? P $9 MC 8 7 6 5 4 3 2 1 MR=D=AR=P Profit = $18 ATC Total Cost=$45 Total Revenue =$63 1 2 3 4 5 6 7 8 9 10 Q Copyright ACDC Leadership 2015 10 Suppose the market demand falls. What would happen if the price is lowered from $7 to $5? The MR=MC rule still applies but now the firm will make an economic loss. The profit maximizing rule is also the loss minimizing rule!!! Copyright ACDC Leadership 2015 11 Cost and Revenue •How much output should be produced? •How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much? MC $9 8 ATC 7 6 Loss =$7 5 MR=D=AR=P 4 3 2 Total Cost = $42 Total Revenue=$35 1 1 2 3 4 5 6 7 8 9 10 Q 12 Assume the market demand falls even more. If the price is lowered from $5 to $4 the firm should stop producing. Shut Down Rule: •A firm should continue to produce as long as the price is above the AVC •When the price falls below AVC then the firm should minimize its losses by shutting down •Why? If the price is below AVC the firm is losing more money by producing than they would have to pay to shut down. Copyright ACDC Leadership 2015 13 P<AVC. They should shut down Producing nothing is cheaper than staying open. Price $9 8 7 6 5 4 3 2 1 MC ATC Fixed Costs=$10 AVC TC=$35 MR=D=AR=P TR=$20 1 2 3 4 5 6 7 8 9 10 Q Copyright ACDC Leadership 2015 14 SHORT-RUN SUPPLY CURVE Cost and Revenues (Dollars) Firms produce where MR=MC e P5 P3 P2 P1 MR5 d P4 MC ATC c AVC b a MR4 MR3 MR2 MR1 This Price is Below AVC And Will Not Be Produced 0 Q2 Q3 Q4 Quantity Supplied Q5 9-15 SHORT-RUN SUPPLY CURVE Firms produce where MR=MC Cost and Revenues (Dollars) Examine the MC for the Competitive Firm MC Above AVC Becomes the Short-Run Supply Curve Break-even (Normal Profit) Point e P5 P3 P2 P1 MC MR5 d P4 S ATC c AVC b a MR4 MR3 MR2 MR1 Shut-Down Point (If P is Below) 0 Q2 Q3 Q4 Quantity Supplied Q5 9-16 Profit Maximizing Rule MR = MC Three Characteristics of MR=MC Rule: 1. Rule applies to ALL markets structures (PC, Monopolies, etc.) 2. The rule applies only if price is above AVC 3. Rule can be restated P = MC for perfectly competitive firms (because MR = P) Copyright ACDC Leadership 2015 17 PRACTICE Copyright ACDC Leadership 2015 18 #1 1. Should the firm produce? Yes 2. What output should the firm produce? 10 3. What is the TR and TC at that output? TR=$140 4. How much profit or loss? TC=$100 Profit=$40 Price MC $16 15 14 MR=D=AR= P ATC 10 9 5 0 Copyright ACDC Leadership 2015 3 7 10 12 Quantity 19 What output should the firm produce? 6 What is TR at that output? $90 What is TC? $120 How much profit or loss? Loss= $30 #2 Price MC 24 ATC 20 18 AVC 15 MR=D=AR=P 12 Copyright ACDC Leadership 2015 0 3 6 8 10 Quantity 20 #3 1. What output should the firm produce? Zero Shutdown 2. What is TR at MR=MC point? $45 (Price below AVC) 3. What is TC at MR=MC point? $55 4. How much profit or loss? Loss=Only Fixed Cost $5 MC Price ATC AVC $12 11 10 MR=D=AR=P 9 0 Copyright ACDC Leadership 2015 5 6 7 8 Quantity 21 #4 1. Should the firm produce? Yes 2. What output should the firm produce? 10 3. What is the TR and TC at that output? TR=$100 4. How much profit or loss? TC=$60 Profit=$40 Price MC $12 11 10 MR=D=AR= P ATC 6 5 3 0 Copyright ACDC Leadership 2015 3 7 10 12 Quantity 22 MAXIMIZING PROFIT Output Variable Fixed Cost Cost 0 1 2 3 4 5 6 $0 $12 $22 $27 $40 $60 $100 $20 Total Cost Marginal Cost - Assume the firm can sell each unit at a price of $30 1. How many units should the firm produce to maximize profit? 2. What is the total revenue at that quantity? 3. How much is the profit? Notice that at 6 units the firm is still making profit. It’s just not maximizing profit Copyright ACDC Leadership 2015 23 MAXIMIZING PROFIT Output Variable Fixed Cost Cost 0 1 2 3 4 5 6 $0 $12 $22 $27 $40 $60 $100 $20 Total Cost Marginal Cost - TR MR Profit $30 $60 $90 $120 $150 $180 $30 $30 $30 $30 $30 $30 -$2 $18 $43 $60 $70 $60 Notice that at 6 units the firm is still making profit. It’s just not maximizing profit Copyright ACDC Leadership 2015 24 SHORT-RUN SUPPLY CURVE Copyright ACDC Leadership 2015 25 Marginal Cost and Individual Supply Cost and Revenue Notice: As price increases, the quantity increases $5 0 45 40 35 30 25 20 15 10 5 0 MC ATC MR5 AVC MR4 MR3 MR2 MR1 1 2 3 4 5 6 7 9 Q 26 Marginal Cost and Supply Cost and Revenue Notice: The firm will not produce when MC is below AVC $5 0 45 40 35 30 25 20 15 10 5 0 Copyright ACDC Leadership 2015 MC = Supply ATC Short-run Supply Curve: AVC MC above AVC 1 2 3 4 5 6 7 9 Q 27 Marginal Cost and Supply Cost and Revenue If variable costs increase (ex: per unit tax) $5 0 45 40 35 30 25 20 15 10 5 0 Copyright ACDC Leadership 2015 MC2=Supply2 MC1=Supply1 AVC AVC When MC increases, SUPPLY decrease 1 2 3 4 5 6 7 9 Q 28 Marginal Cost and Supply Cost and Revenue What if variable costs decrease (ex: subsidy)? $5 0 45 40 35 30 25 20 15 10 5 0 Copyright ACDC Leadership 2015 MC1=Supply1 MC2=Supply2 AVC AVC When MC decreases, SUPPLY increases 1 2 3 4 5 6 7 9 Q 29 Marginal Cost and Supply What happens to quantity if fixed costs increase? Price MC MR=D=AR= P ATC1 ATC PF Quantity stays the same because MC/Supply doesn’t change Copyright ACDC Leadership 2015 QF Quantity 30 Per Unit vs. Lump Sum A PER UNIT tax or subsidy affects the VARIABLE COSTS so MC, AVC, and ATC will shift. This WILL affect the quantity produced A LUMP SUM tax or subsidy only affects FIXED COSTS so only AFC and ATC will shift. MC stays the same. This WILL NOT affect the quantity produced Copyright ACDC Leadership 2015 31 2008 Audit Exam