Microeconomics Chapter 11 Costs and Profit Maximization under Competition

Just because a firm is maximizing profits doesn't mean that it is making profits.

-If P < AC the firm is taking a loss. -If P > AC the firm is making a profit. -when P=AC, profits are zero and there is neither exit or entry. -figure 11.5 -when marginal cost is just below average cost, the average cost curve is falling and when marginal cost is just above average cost, the average cost curve is rising, so AC and MC must meet at the minimum of the AC curve.

short run shut down decision

-P < AC -if a company is paying rent they will benefit by not shutting down immediately -firm can cover all variable costs and some of its fixed costs. Loss when -TR < TC

Entry and Exit

-When P > AC firms enter. -when P< AC firms exit -when P=AC no profit. -example of long run entry of exit.

What Price to set?

-You can't sell oil at a price above the market price and you can sell all you oil at the market price. -to maximize profit, you sell at the market price. -Your demand for your oil is flat or completely elastic at the world price (lots of substitutes)

The Firm's Entry, Exit, and Shutdown Decisions

-if the price is below the minimum of the AVC curve, then the firm should shut down and exit as soon as possible. -If the price is above the AVC curve but below the AC curve, then the firm should produce the q such that P=MC but exit ASAP. -it the price is at or above the AC Curve, the firm should remain within the industry producing where P=MC or enter.

Explicit costs

-is a cost that requires a money outlay. -ex cost of flowers when running a flower shop -payed out of pocket by writing a check

Fixed cost are irrelevant

-since fixed costs don't change when we increase output, they don't influence marginal costs. P=MC will give us the same profit maximizing quantity whether fixed costs are high or low.

Marginal cost

-the change in Toal cost form producing an additional unit. -in order to maximize profit, you keep producing until marginal revenue= Marginal cost. - =Change in total cost/ change in quantity.

Marginal revenue

-the change in total revenue from selling an additional unit. MR= change in total revenue/ change in quantity. -for a firm in a competitive industry, MR=Price, perfectly elastic demand curve.

Figure 11.1 Market Demand and Firm Demand

-the price of oil is determined in the world market for oil. You can't sell oil at a price above the market price. At the market price, you can sell as many barrels of as you want.

Conditions for a competitive market

-the product being sold is similar across sellers. -there are many buyers and sellers, each small relative to the total market. -there are many potential sellers.

Industry supply curve

-to find the quantity supplied by the industry, add the quantities supplied by each firm in the industry. -figure 11.7

When is a firm competitive?

-when sellers don't have influence over the price of their product. Conditions -products being sold is similar across sellers. -many buyers and sellers, each small relative to the total market. -many potential sellers.

Figure 11.9, Increasing cost, constant cost, and decreasing cost industries.

An upward-sloped curve implies that costs increase with greater industry output, an increasing cost industry. A flat supply curve indicates that costs do not change with industry output, a constant cost industry. A downward-sloping curve implies that costs fall with greater industry output, a decreasing cost industry.

When should a firm shut down immediately?

P < (VC/Q)= AVC

Total revenue

Price x Quantity

Profit= (P-AC) x Q

Profit is (P-AC) X Q, profit per barrel times the number of barrels produced. When the price is $50 and 8 barrels of oil are produced, profit is shown on the graph as the shaded area. Notice that the price is the height of point a, AC is the height fo point b, so that the area (a-b) X Q is equal to profit or $194= (50-25.75) x 8. -figure 11.4

Profit

Profit= (P-AC) x Q

As the price changes, so does the profit-maximizing quantity

The profit-maximizing quantity is found where P=MC. At a price of $50, the profit-maximizing quantity is 8. As the price rises to $100, the firm expands. At $100, the profit- maximizing quantity is approximately 9.4 barrels per day. -figure 11.3

Long run

The time after all exit or entry has occurred. -demand curves elastic in the long run. -lots of sellers -lots of subs

How a constant Cost Industry Adjusts to an Increase in Demand

The top panel shows the initial industry and firm equilibrium. The market market price for domain name registration is $8.99 and each firm is making a normal profit. In the middle panel, the demand for registers increases, which pushes up the market price to $9.99. In the short run, each firm in the industry expands along its MC curve and thus market quantity increases to Qsr. Each firm earns above-normal profits. In the bottom panel, the above-normal profits attract entry. This increases supply until price returns to $8.99. At that price, firms once again are earning normal profits, since P=AC.

Profit is maximized by Producing until MR=MC

To maximize profit, a firm compares the revenue form selling an additional unit, marginal revenue to the costs of selling an additional unit, marginal cost. Profit increases form an additional sale whenever MR > MC so profit is maximized by producing up until the point where MR=MC. -Figure 11.2 P=MC

decreasing cost industry

an industry in which industry costs decrease with an increase in output; shown with a downward-sloped supply curve. -ex. Silicon Valley -Hollywood, everything is already there to film a movie.

Constant cost industry

an industry in which industry costs do not change with greater output; shown with a flat supply curve. -very boring, ex. toothpick industries -marginal cost is 0.

increasing cost industry

an industry in which industry costs increase with greater output; shown with an upward-sloped supply curve. -Ex. oil costs more and more to drill for different places -universities, knowledge costs more and more.

implicit costs

cost that does not require an outlay of money. -ex. loss of interest income on funds.

Variable costs

costs that do vary with output. -Ex. pumping more oil more oil will require more electricity and maintenance costs for the pump.

Fixed Costs

does not vary with the quantity produced. -can change in the long run, should be focused on for long run decisions like entry of exit. -do not vary with output, example rent.

sunk cost

is a cost that cant be recovered. -ignore what you cant change -ex cost of drilling a well for oil -should ignore higher rent when deciding what quantity to produce.

Zero Profits or Normal Profits

occur when P= AC. at this price the firm is covering all of its costs, including enough to pay labor and capital their ordinary opportunity costs.

Total cost

the cost of producing a given quantity of output. -Total cost= fixed cost + variable costs

Short run

the period before exit or entry can occur -could raise prices in the short run, but would attract lots of potential sellers.

Average Cost

total cost of producing Q units divided by Q. AC= TC/Q

Profit

total revenue minus total cost -owner wants to maximize this

economic profit

total revenue minus total cost, including both explicit and implicit costs -firms want to maximize economic profit, not accounting profit.

accounting profits

total revenue- explicit cost