Economia Cap 11

Managerial decisions in competitive markets

Economic profit = Total revenue - Total economic cost = Total revenue - Explicit costs - Implicit
costs

The most important characteristic of perfectly competitive markets is that each firm in a
competitive market behaves as a price-taker: Competitive firms take the market price of the
product, which is determined by the intersection of supply and demand, as given. This price-
taking behavior is the hallmark of a competitive market. In all other market structures
monopoly, monopolistic competition, and oligopolyfirms enjoy some degree of price-setting
power. Three characteristics define perfect competition:
1. Perfectly competitive firms are price-takers because each individual firm in the market is so
small relative to the total market that it cannot affect the market price of the good or service it
produces by changing its output. Of course, if all producers act together, changes in quantity will
definitely affect market price. But if perfect competition prevails, each producer is so small that
individual changes will go unnoticed.
2. All firms produce a homogeneous or perfectly standardized commodity. The product of each
firm in a perfectly competitive market is identical to the product of every other firm. This
condition ensures that buyers are indiffer- ent as to the firm from which they purchase. Product
differences, whether real or imaginary, are precluded under perfect competition.
3. Entry into and exit from perfectly competitive markets are unrestricted. There are no barriers
preventing new firms from entering the market, and nothing prevents existing firms from leaving
a market.
11.2 DEMAND FACING A PRICE-TAKING FIRM

You wish to determine the maximum price you can charge for various levels of output of frozen
concentrate; that is, you wish to find the demand schedule facing your firm. After consulting The
Wall Street Journal, you find that the market-determined price of orange juice concentrate is
$1.20 per pound. You have 50,000 pounds of con- centrate to sell, which makes your output
minuscule compared with the tens of mil- lions of pounds of orange juice concentrate sold in the
market as a whole. On top of that, you realize that buyers of orange juice concentrate dont care
from whom they buy since all orange juice concentrate is virtually identical (homogeneous).
All at once it hits you like a ton of oranges: You can sell virtually all the orange juice concentrate
you wish at the going market price of $1.20 per pound. Even if you increased your output tenfold
to 500,000 pounds, you could still find buyers willing to pay you $1.20 per pound for the entire
500,000 pounds because your output, by itself, is not going to affect (shift) market supply in any
perceptible way. Indeed, if you lowered the price to sell more oranges, you would be need- lessly
sacrificing revenue. You also realize that you cannot charge a price higher than $1.20 per pound
because buyers will simply buy from one of the thousands of other citrus producers that sell
orange juice concentrate identical to your own.
By this reasoning, you realize that the demand curve facing your citrus grove can be drawn as
shown in Figure 11.1. The demand for your firms product is hori- zontal at a price of $1.20 per
pound of orange juice concentrate. The demand price for any level of orange juice concentrate is
$1.20, no matter how many pounds you produce. This means that every extra pound sold
contributes $1.20 to total revenue, and hence the market price of $1.20 is also the marginal
revenue for ev- ery pound of orange juice concentrate sold. The demand curve facing the citrus
producer is also its marginal revenue curve.
The horizontal demand curve facing a price-taking firm is frequently called a per-fectly (or
infinitely) elastic demand. Recall from Chapter 6 that the point elasticity of demand is measured
by E = P/(P - A), where A is the price intercept of the demand curve. Measured at any given
price, as demand becomes flatter, |P - A| becomes smaller and |E| becomes larger. In the limit
when demand is horizontal, P - A = 0, and |E| = infinito`. Thus, for a horizontal demand, demand
is said to be infi- nitely elastic or perfectly elastic.
The Output Decision: Earning Positive Economic Profit
Figure 11.3 shows a typical set of short-run cost curves: short-run marginal cost (SMC), average
total cost (ATC), and average variable cost (AVC).
Average profit= pi/Q= (Price-Average Total Cost) Q/Q
Profit margin= (P-ATC)

Lets now compute the profit when the manager mistakenly chooses to produce 400 units. As
you can see in Panel A, at 400 units, total revenue is $14,400, which is price times quantity ($36
x 400), and total cost is $6,400, which is average total cost times quantity ($16 x 400). Profit,
then, is $8,000 (=$14,400 - $6,400) when the firm produces 400 units and maximizes profit
margin. So, whats wrong with making a profit of $8,000?
The answer is simple: This firm could make even more profit$10,200 to be preciseby
producing 600 units, as shown in Panel B. By expanding production from 400 to 600 units, total
profit (p) rises as profit margin falls or, equivalently, as average profit falls. Plenty of highly paid
CEOs find this outcome puzzling. Hardly a day passes that you will not see, somewhere in the
business news, an executive manager bragging about raising profit margins or promising to do so
in the future. We will now clear up this confusion by employing the logic of mar- ginal analysis
presented in Chapter 3.

Return to point N in Panel A where the firm is producing and selling 400 units. Let the manager
increase production by 1 unit to 401 units. Because this firm is a price-taking firm for which
price equals marginal revenue (P = $36 = MR), sell- ing the 401st unit for $36 causes total
revenue to rise by $36. Producing the 401st unit causes total cost to rise by the amount of short-
run marginal cost, which is $16 (approximately). By choosing to produce and sell the 401st unit,
the manager adds $36 to revenue and adds only $16 to cost, thereby adding $20 to the firms
total profit. By this same reasoning, the manager would continue increasing pro- duction as long
as MR (or, equivalently, P) is greater than SMC. From 401 units to 600 units at point A, each
unit adds to total profit the difference between P and SMC. Thus, output should be increased to
600 units, as shown in Panel B, where P = MR 5 SMC = $36. At 600 units, total revenue is
$21,600 (=$36 3 600).

Total cost is $11,400 (=$19 x 600). Thus, the maximum possible profit is $10,200 (=$21,600 -
$11,400). In Panel A, the gray-shaded area below MR and above SMC is equal to the value of
the lost profit when only 400 units are produced instead of 600 units. We can summarize this
very important discussion in a principle:

Managers cannot maximize both profit and profit margin at the same level of output. For this
reason, profit marginor, equivalently, average profitshould be ignored when making profit-
maximizing decisions. When a firm can make positive profit in the short run, profit is maxi-
mized at the output level where MR (= P) = SMC

Now suppose the manager makes the mistake of supplying too much output by producing and
selling 630 units in Panel B. As you can see, marginal revenue (price) is now less than marginal
cost: Price is $36 and marginal cost of the 630th unit is $40 (point H). The manager could
decrease output by 1 unit and reduce total cost by $40 (the cost of the extra resources needed to
produce the 630th unit). The lost sale of the 630th unit would reduce revenue by only $36, so the
firms profit would increase by $4. By the same reasoning, the manager would continue to
decrease production as long as MR (= P) is less than SMC (back to point A). The gray-shaded
area in Panel B is the lost profit from producing 630 units instead of 600 units. It follows from
this discus- sion that the manager maximizes profit by choosing the level of output where MR (=
P) = SMC. This rule is, of course, the rule of unconstrained maximization set forth in Chapter 3
(MB 5 MC) with profit serving as the net benefit (TB - TC) to be maximized.
Figure 11.4 shows the total revenue (TR), total cost (TC), and profit (pi) curves for the situation
presented in Figure 11.3. Notice in Panel A that TR is linear with slope equal to $36 (= P = MR)
since each additional unit sold adds $36 to total revenue. Also note that in Panel B, at 401 units,
the slope of the profit curve is $20, which follows from the preceding discussion about producing
the 401st unit. At 600 units, the maximum profit is $10,200, which occurs at the peak of the
profit curve (point A') where the slope of the profit curve is zero. The points U and V in Figure
11.4 (100 units and 950 units) are sometimes called break-even points because total revenue
equals total cost and the firm earns zero profit.
Since the total cost of producing 600 units ($11,400) includes the opportunity cost of the
resources provided by the firms owners (i.e., the implicit costs), the owners earn $10,200 more
than they could have earned if they had instead em- ployed their resources in their best
alternative. The $10,200 economic profit, then, is a return to the owners in excess of their best
alternative use of their resources.