ECONOMICS FOR MANAGERS

BA533
MODULE 3: Profit
Maximization and Competitive
Supply

Fall 2017 Economics for Managers: Module 3 1

 Topics...
“price taking” behavior
Marginal Revenue
Short-run Supply curve
Shut-down decisions
Market Equilibrium
Consumer Surplus and Producer Surplus
Long-run Equilibrium
Entry and Exit decisions
Fall 2017 Economics for Managers: Module 3 2
 Module 3 Assignments
Background material from P & R noted
on the syllabus
Practice Problems 13 - 19
Study Guide:

Chapter 8 Problems

1 - 9, 12 - 14, 18, 19, 21, 23,

24, 26, 27

Fall 2017 Economics for Managers: Module 3 3

 Market Equilibrium
“price taker” “price setter”

Perfect Oligopoly Monopoly

Competition

Fall 2017 Economics for Managers: Module 3 4

 A Competitive Market

Homogenous Products
Lots of Buyers and Sellers
Everyone has perfect knowledge of all
market opportunities
Perfect mobility of resources between
different occupations (“free entry”)

Fall 2017 Economics for Managers: Module 3 5

 A Couple of Results...
Homogenous Products
+
Perfect Knowledge of market opportunities

The “Law of a Single Price”

Fall 2017 Economics for Managers: Module 3 6

 A Couple of Results...

Lots of Buyers Price-taking

and Sellers Behavior

Both buyers and sellers observe the market

price, and believe that they cannot affect it
by their own actions.

Fall 2017 Economics for Managers: Module 3 7

 The Consumer’s Decision
Each consumer observes the market
price p*, and purchases the amount that
maximizes her consumer surplus.

p*
Consumer
Demand

q
Fall 2017 Economics for Managers: Module 3 8
 The Firm’s Decision
The firm observes the market price p*,
and produces a quantity that maximizes
profit.
The Marginal Revenue from producing
1 more unit is the market price, p*.
Total Total
Total - -
= Revenues
Variable Fixed
Costs Costs

Depend on quantity
Fall 2017 Economics for Managers: Module 3 9
 The Firm’s Decision
The Demand curve seen
by an Individual Firm
MC

p* D

P = MC

q q+1
1 2

Fall 2017 Economics for Managers: Module 3 10

 Why are perfectly competitive firms
“price takers”?
Intuition: As the number of firms increases, the number of
substitutes for consumers increases, so the demand curve faced
by an individual firm becomes more and more elastic at the
going market price.

ELASTICITY ESTIMATES FOR AGRICULTURE

Crop Market Elasticity Individual Farm Elasticity
Apples -0.21 -8,649
Pears -1.64 -21,711
Corn -0.33 -809
Lettuce -1.06 -29,260
Fall 2017 Economics for Managers: Module 3 11
 Producer Surplus
“producer surplus” MC
Total Revenue
p*
Total variable
cost

q
Fall 2017 Economics for Managers: Module 3 12
 The Result...

Producer Total Total Variable

= -
Surplus Revenues Costs

and...
Total Fixed
= TR - TVC - Costs

Producer surplus
Fall 2017 Economics for Managers: Module 3 13
The Tuna Fisherman “Story”...
The fisherman observes the market price
to be p*, and catches fish until P* = MC.
Upon returning to shore, the fisherman
sells her catch, q, for total revenues of p*q.
Out of those total revenues (TR), she pays
her total variable costs (TVC), leaving her
with some producer surplus.
If the producer surplus is larger than her
fixed costs, she has made a positive profit.
Fall 2017 Economics for Managers: Module 3 14
 Competitive Supply

When does a firm decide to

operate, and how much does it
produce?

Fall 2017 Economics for Managers: Module 3 15

 Competitive Supply
MC
ATC

AFC AVC

Fall 2017 Economics for Managers: Module 3 16

 Competitive Supply
MC
pH
ATC
>0

AVC

qH
Fall 2017 Economics for Managers: Module 3 17
 Competitive Supply
MC
<0 ATC

pm AVC

PS > 0

qm
Fall 2017 Economics for Managers: Module 3 18
 Competitive Supply
MC
ATC

AVC
PS < 0
pL

qL

Fall 2017 Economics for Managers: Module 3 19

 Competitive Supply
At pH:
Profit is positive (so producer surplus > total
fixed costs).
At pM:
Profit is negative, but producer surplus covers
some fixed costs it pays to produce.
At pL:
Even producer surplus is negative it isn’t
worth producing shut down.
Fall 2017 Economics for Managers: Module 3 20
 Competitive Supply
Firm’s
MC
Supply
ATC

AVC

“Shut-down” point

Fall 2017 Economics for Managers: Module 3 21

 Market Equilibrium
The market demand curve is the
horizontal summation of the individual
demand curves of all of the consumers
in the market.
The market supply curve is the
horizontal summation of the individual
supply curves of all of the firms in the
market.
In the short run, the number of firms is
fixed
Fall 2017 Economics for Managers: Module 3 22
 Market Equilibrium
p*,Q*
S Market
Supply

p*
Market
Demand
D

Q*
Fall 2017 Economics for Managers: Module 3 23
 Market Equilibrium
Excess Supply
price falls S
pH
p*

pL Excess Demand D
price increases

Q*
Fall 2017 Economics for Managers: Module 3 24
 Market Equilibrium
Loss in Consumers’
and Producers’ surplus

CS S
p*
PS
D

QL Q*
Fall 2017 Economics for Managers: Module 3 25
 Market Equilibrium
Negative
producer
surplus

CS S
Negative
p* consumer
surplus
PS
D

Q* QH
Fall 2017 Economics for Managers: Module 3 26
 Market Equilibrium in the
“Short Run”
The equilibrium price p* clears the market.
No excess supply or excess demand.
This is a “positive result”: why the market
price is what it is.
Firms can make positive profit in the short
run (we will examine “free entry” in a
minute…).
Fall 2017 Economics for Managers: Module 3 27
 Market Equilibrium in the
Short Run
The equilibrium quantity Q* maximizes the
Total Benefits of Production (= CS + PS).
No other quantity can make society better off!
This is a “normative result”: Even a dictator
cannot improve on the competitive market.

The “technical” Result:

P = MC
Fall 2017 Economics for Managers: Module 3 28
 Adam Smith: “Economist”

Fall 2017 Economics for Managers: Module 3 29

 “Every individual necessarily labors to
render the annual revenue of society as
great as he can. He generally, indeed,
never intends to promote the public
interest, nor knows how much he is
promoting it….He intends only his own
gain, and he is led by an invisible hand to
promote an end which was no part of his
intention. By pursuing his own interest, he
frequently promotes that of society more
effectively than when he really intends to
promote it.”
--Adam Smith, 1776

Fall 2017 Economics for Managers: Module 3 30

The Big Result:
Individual
Self-Interest

“INVISIBLE HAND”

A good outcome
for Society

Fall 2017 Economics for Managers: Module 3 31

 Let’s Look at the “Long Run”
Profit in the short run will attract
entry of other firms into the
market!

The Result: Zero "Economic" Profit

Fall 2017 Economics for Managers: Module 3 32

 Market Equilibrium with Entry
Firm Market
MC S
ATC
p*
S’

p**
D

Fall 2017 Economics for Managers: Module 3 33

 Market Equilibrium in the
Long Run
In the long run, positive profits by firms
in the market will attract entry.
This entry will depress the market price.
Entry will continue until economic profits
are driven to zero.
The Long Run Result:
P = min ATC

Fall 2017 Economics for Managers: Module 3 34

 Competitive Equilibrium:
A Summary
In the short run, P = MC
The Total Benefits of Production are
Maximized (The Invisible Hand Result)
And, in the long run, P = min ATC also
Free entry has driven price as low as it can
be, subject to the constraint that firms don’t
make losses
Consumer surplus is maximized subject to
the constraint that 0
Fall 2017 Economics for Managers: Module 3 35
 Adam Smith anticipated this,
too...
“Consumption is the sole end and purpose
of all production; and the interest of the
producer ought to be attended to only so
far as it may be necessary for promoting
that of the consumer.”
Translation: Give the firms only what
they require to stick around ( =0), and
no more
Fall 2017 Economics for Managers: Module 3 36