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Distribution of Grades: Midterm #2

This text discusses the distribution of grades for Midterm #2, with a mean of 28.30 and a median of 29. It also covers the concepts of profit maximization and competitive supply in perfectly competitive markets, including the assumptions, behavior, and objectives of firms in such markets.

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Distribution of Grades: Midterm #2

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  1. Distribution of Grades Midterm #2 25 20 15 10 5 0 10 15 20 25 30 35 40 45 50 Mean = 28.30 Median = 29 Chapter 8

  2. Chapter 8 Profit Maximization and Competitive Supply

  3. Perfectly Competitive Markets • The model of perfect competition can be used to study a variety of markets • Basic assumptions of Perfectly Competitive Markets • Price taking • Product homogeneity • Free entry and exit Chapter 8

  4. When are Markets Competitive? • Few real products are perfectly competitive • Many markets are, however, highly competitive • They face relatively low entry and exit costs • Highly elastic demand curves • No rule of thumb to determine whether a market is close to perfectly competitive • Depends on how they behave in situations Chapter 8

  5. Profit Maximization • Do firms maximize profits? • Managers in firms may be concerned with other objectives • Revenue maximization • Revenue growth • Dividend maximization • Short-run profit maximization (due to bonus or promotion incentive) • Could be at expense of long run profits Chapter 8

  6. Profit Maximization • Implications of non-profit objective • Over the long run, investors would not support the company • Without profits, survival is unlikely in competitive industries • Managers have constrained freedom to pursue goals other than long-run profit maximization Chapter 8

  7. Marginal Revenue, Marginal Cost, and Profit Maximization • We can study profit maximizing output for any firm, whether perfectly competitive or not • Profit () = Total Revenue - Total Cost • If q is output of the firm, then total revenue is price of the good times quantity • Total Revenue (R) = Pq Chapter 8

  8. Marginal Revenue, Marginal Cost, and Profit Maximization • Costs of production depends on output • Total Cost (C) = C(q) • Profit for the firm, , is difference between revenue and costs Chapter 8

  9. C(q) A R(q) B q* q0 (q) Profit Maximization – Short Run Profits are maximized where MR (slope at A) and MC (slope at B) are equal Cost, Revenue, Profit ($s per year) Profits are maximized where R(q) – C(q) is maximized 0 Output Chapter 8

  10. Marginal Revenue, Marginal Cost, and Profit Maximization • Profit is maximized at the point at which an additional increment to output leaves profit unchanged Chapter 8

  11. Marginal Revenue, Marginal Cost, and Profit Maximization • The Competitive Firm • Price taker – market price and output determined from total market demand and supply • Market output (Q) and firm output (q) • Market demand (D) and firm demand (d) Chapter 8

  12. The Competitive Firm • Demand curve faced by an individual firm is a horizontal line • Firm’s sales have no effect on market price • Demand curve faced by whole market is downward sloping • Shows amount of goods all consumers will purchase at different prices Chapter 8

  13. Price $ per bushel Price $ per bushel S $4 d $4 D Output (bushels) Output (millions of bushels) 100 200 100 The Competitive Firm Firm Industry Chapter 8

  14. The Competitive Firm • The competitive firm’s demand • Individual producer sells all units for $4 regardless of that producer’s level of output • MR = P with the horizontal demand curve • For a perfectly competitive firm, profit maximizing output occurs when Chapter 8

  15. Choosing Output: Short Run • In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits • We can look at the graph of MR, MC, ATC and AVC to determine profits • The point where MR = MC, the profit maximizing output is chosen Chapter 8

  16. MC Price Lost Profit for q2>q* 50 Lost Profit for q1 < q* AR=MR=P 40 ATC AVC 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output q1 q* q2 A Competitive Firm A q1 : MR > MC q2: MC > MR q*: MC = MR Chapter 8

  17. MC Price 50 A D AR=MR=P 40 ATC AVC 30 C 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output q1 q* q2 A Competitive Firm – Positive Profits Total Profit = ABCD Profits are determinedby output per unit times quantity B Profit per unit = P-AC(q) = A to B Chapter 8

  18. The Competitive Firm • A firm does not have to make profits • It is possible a firm will incur losses if the P < AC for the profit maximizing quantity • Still measured by profit per unit times quantity • Profit per unit is negative (P – AC < 0) Chapter 8

  19. MC ATC B C D P = MR A AVC q* A Competitive Firm – Losses Price At q*: MR = MC and P < ATC Losses = (P- AC) x q* or ABCD Output Chapter 8

  20. Choosing Output in the Short Run • Summary of Production Decisions • Profit is maximized when MC = MR • If P > ATC the firm is making profits • If P < ATC the firm is making losses Chapter 8

  21. Short Run Production • Why would a firm produce at a loss? • Might think price will increase in near future • Shutting down and starting up could be costly • Firm has two choices in short run • Continue producing • Shut down temporarily • Will compare profitability of both choices Chapter 8

  22. Short Run Production • When should the firm shut down? • If AVC < P < ATC, the firm should continue producing in the short run • Can cover all of its variable costs and some of its fixed costs • If AVC > P < ATC, the firm should shut down • Cannot cover its variable costs or any of its fixed costs Chapter 8

  23. MC ATC Losses B C D P = MR A AVC F E q* A Competitive Firm – Losses Price • P < ATC but • AVC so firm will continue to produce in short run Output Chapter 8

  24. Competitive Firm – Short Run Supply • Supply curve tells how much output will be produced at different prices • Competitive firms determine quantity to produce where P = MC • Firm shuts down when P < AVC • Competitive firms’ supply curve is portion of the marginal cost curve above the AVC curve Chapter 8

  25. S ATC P2 AVC P1 P = AVC q1 q2 A Competitive Firm’sShort-Run Supply Curve Price ($ per unit) The firm chooses the output level where P = MR = MC, as long as P > AVC. Supply is MC above AVC MC Output Chapter 8

  26. MC2 Savings to the firm from reducing output MC1 $5 q2 q1 The Response of a Firm toa Change in Input Price Price ($ per unit) Input cost increases and MC shifts to MC2 and q falls to q2. Output Chapter 8

  27. Short-Run Market Supply Curve • Shows the amount of product the whole market will produce at given prices • Is the sum of all the individual producers in the market • We can show graphically how we can sum the supply curves of individual producers Chapter 8

  28. S MC1 MC3 MC2 P3 P2 P1 2 4 7 8 10 15 21 5 Industry Supply in the Short Run The short-run industry supply curve is the horizontal summation of the supply curves of the firms. $ per unit Q Chapter 8

  29. Long-Run Competitive Equilibrium • For long run equilibrium, firms must have no desire to enter or leave the industry • Relate economic profit to the incentive to enter and exit the market • Relate accounting profit to economic profit Chapter 8

  30. Long-Run Competitive Equilibrium • Accounting profit • Difference between firm’s revenues and direct costs • Economic profit • Difference between firm’s revenues and direct and indirect costs • Takes into account opportunity costs Chapter 8

  31. Long-Run Competitive Equilibrium • Firm uses labor (L) and capital (K) with purchased capital • Accounting Profit and Economic Profit • Accounting profit:  = R - wL • Economic profit:  = R = wL - rK • wl = labor cost • rk = opportunity cost of capital Chapter 8

  32. Long-Run Competitive Equilibrium • Zero-Profit • A firm is earning a normal return on its investment • Doing as well as it could by investing its money elsewhere • Normal return is firm’s opportunity cost of using money to buy capital instead of investing elsewhere • Competitive market long run equilibrium Chapter 8

  33. Long-Run Competitive Equilibrium • Zero Economic Profits • If R > wL + rk, economic profits are positive • If R = wL + rk, zero economic profits, but the firm is earning a normal rate of return, indicating the industry is competitive • If R < wl + rk, consider going out of business Chapter 8

  34. Long-Run Competitive Equilibrium • Entry and Exit • The long-run response to short-run profits is to increase output and profits • Profits will attract other producers • More producers increase industry supply, which lowers the market price • This continues until there are no more profits to be gained in the market – zero economic profits Chapter 8

  35. S1 LMC $40 P1 LAC S2 P2 $30 D q2 Q1 Q2 Long-Run Competitive Equilibrium – Profits • Profit attracts firms • Supply increases until profit = 0 $ per unit of output $ per unit of output Firm Industry Output Output Chapter 8

  36. S2 LMC $30 P2 LAC S1 P1 $20 D Q2 Q1 q2 Long-Run Competitive Equilibrium – Losses • Losses cause firms to leave • Supply decreases until profit = 0 $ per unit of output $ per unit of output Firm Industry Output Output Chapter 8

  37. Long-Run Competitive Equilibrium • All firms in industry are maximizing profits • MR = MC • No firm has incentive to enter or exit industry • Earning zero economic profits • Market is in equilibrium • QD = QS Chapter 8

  38. Choosing Output in the Long Run • Economic Rent • The difference between what firms are willing to pay for an input less the minimum amount necessary to obtain it • When some have accounting profits that are larger than others, they still earn zero economic profits because of the willingness of other firms to use the factors of production that are in limited supply Chapter 8

  39. Choosing Output in the Long Run • An Example • Two firms A & B that both own their land • A is located on a river which lowers A’s shipping cost by $10,000 compared to B • The demand for A’s river location will increase the price of A’s land to $10,000 = economic rent • Although economic rent has increased, economic profit has become zero Chapter 8

  40. LMC LAC $7 1.0 Firms Earn Zero Profit inLong-Run Equilibrium Ticket Price A baseball team in a moderate-sized city sells enough tickets so that price is equal to marginal and average cost (profit = 0). Season Tickets Sales (millions) Chapter 8

  41. LMC LAC Economic Rent $10 $7.20 1.3 Firms Earn Zero Profit inLong-Run Equilibrium Ticket Price A team with the same cost in a larger city sells tickets for $10. Season Tickets Sales (millions) Chapter 8

  42. Firms Earn Zero Profit inLong-Run Equilibrium • With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input Chapter 8

  43. Firms Earn Zero Profit inLong-Run Equilibrium • If the opportunity cost of the input (rent) is not taken into consideration, it may appear that economic profits exist in the long run (positive accounting profits) Chapter 8

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