finishing costs and starting profit maximization in perfect...

Course information

 Finishing costs and starting profit maximization in perfect competition

 Homework due this Sunday night  Midterm Wednesday April 4 in class. Bring

#2 pencils and calculators. Covers chapters on consumer choice/equilibrium and production costs

A firm increases plant size and labor employed by the same percentage Output increases by a smaller percentage Average total cost increases Why? Difficulty of coordinating and controlling a large enterprise. Eventually, management complexity brings rising average total cost.

Diseconomies of scale

A firm increases its plant size and labor employed by the same percentage

Output increases by the same percentage

Average total cost remains constant.

Why? A firm is able to replicate its existing production facility including its management system.

Constant returns to scale

The long-run average cost curve

shows the lowest average cost at which it is possible to produce each output

when the firm has had sufficient time to change both its plant size and labor employed.

What this looks like

Can vary all inputs to change the size (scale)

With its current plant, Sam’s ATC curve is ATC1.

With successively larger plants, Sam’s ATC curves would be ATC2, ATC3, and ATC4.

Long-run average cost curve

Which Store Has the Lower Costs: Wal-Mart or 7–11?

EYE on RETAILERS’ COSTS

Wal-Mart’s “small” supercenters measure 99,000 square feet and serve an average of 30,000 customers a week.

The average 7–11 store, mostly attached to gas stations, measures 2,000 square feet and serves 5,000 customers a week.

Which retailing technology has the lower operating cost?

The answer depends on the scale of operation. At a small number of customers per week, it costs less per customer to operate a store of 2,000 square feet than a store of 99,000 square feet.

Which Store Has the Lower Costs: Wal-Mart or 7–11?

EYE on RETAILERS’ COSTS

The average total cost curve of operating a store of 2,000 square feet is ATC7–11. The average total cost curve of a store of 99,000 square feet is ATCWal-Mart. The dark blue curve is a retailer’s LRAC curve.

Which Store Has the Lower Costs: Wal-Mart or 7–11?

EYE on RETAILERS’ COSTS

With Q customers a week, the average total cost of a transaction is the same in both stores. For a store that serves fewer than Q customers a week, the least-cost method is the small store.

Profit maximization in perfect competition

 What is profit? TR – TC

 What is perfect competition? No consumer or producer can influence the market price – all price takers

Concentration in US manufacturing: All companies

Concentration ratios by sector

Concentration ratios by sector continued

Maximizing profit

How to do it? 2 methods: TR & TC and MR & MC Maximize profit where 1.  maximize difference between TR and

TC or (equivalently) 2.  MR = MC

Slope of the MR curve

 MR is the price paid for each additional unit

 Constant because of perfect competition

 Market price is given to all firms

 Can only sell at that price no matter how much they sell

Slope of the TR curve

 Constant because MR is constant

 MR constant because of perfect competition where firm is a price taker

 Graph of the TR curve is a straight line

The revenue side – marginal revenue

The revenue side – total revenue

Marginal and total revenue MR comes from market price. The table shows the calculations of TR and MR.

Finding maximum profit with TR and TC

Profit is maximized at the output level at which TR revenue exceeds TC by the largest amount.

Why? Because total profit = total revenue – total cost

Have TR: now need to add TC. We have seen the shape of this in the previous chapter, so nothing new here!

TR, TC and profit graphically

Second approach: Profit maximization through MR and MC rather than TR and TC

If MR > MC, the extra revenue from selling one more unit exceeds the extra cost incurred to produce it.

Economic profit increases if output increases.

The opposite holds if MC > MR.

Profit maximizing level of putput

 Put MC and MR together

 Have from perfect competition and the market price the MR curve (horizontal)

 And have the MC curve shape from the previous chapter

MR, MC and profit maximization graphically

First decision: find the profit maximizing output

This is the best the firm can do. But, is it good enough? What is profit at this profit maximizing point?

Profit maximizing equilibrium: Add AC

The second decision: stay open or shut down

 Temporary Shutdown Decisions If a firm is incurring an economic loss that it believes is temporary, it will remain in the market, and it might produce some output or temporarily shut down.

What happens and why fixed and variable costs are important

1. If the firm shuts down temporarily, it incurs an economic loss = TFC.

2. If the firm produces some output, it incurs an economic loss equal to TFC + TVC – TR.

3.  If TR > TVC, the firm’s economic loss is less than TFC.

4.  So it pays the firm to produce and incur an economic loss. It can pay some of TFC even if not all.

Decision rule for shutting down

So the firm produces some output if P > AVC

but shuts down temporarily if AVC > P

Because by producing any output at all it increases its losses.

Shutdown point

The output and price at which price equals minimum average variable cost.

Below that point can’t set aside anything to cover fixed costs.

Better to shut down.

Shut down point graphically