ECON 221 Lecture 16Outline of Last Lecture I. Firms decision-makinga. Maximizing profitsb. Different types of competition II. Cost Curvesa. Total Cost Curveb. Average Total Cost CurveIII. Short Run vs. Long Run costsIV. Market Structure Outline of Current Lecture I. Profit MaximizationII. Market Profitability III. Short-Run Production IV. Breakeven PriceV. Shutdown PriceCurrent Lecture- Many buyers, many sellers (with very little market power)- Identical products - Buyers and sellers are price takers- Free entry and exit of marketso Because a firm is a price taker, they cannot impact pricesThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute. The firm always receives the market price when it sells a unit of a good  MR always equals price, regardless of quantity produced (for perfectly competitive firms)- Profit Maximization o Profit = TQ(Q(K,L)) - TC(Q(K,L))o A firm wants to produce one more unit of a good if it will add to profit  That is, add to profit if: TR(Q+1) – TC(Q+1) > TR(Q) – TC(Q) [TR(Q)+MR(Q)]-[TC(Q)+MC(Q)] > TR(Q)-TC(Q) MR(Q) >MC(Q)  For perfectly competitive markets, produce more if P > MC (Q) Stop at the Q where P = MC(Q)o When price goes up: Quantity produced goes up (Law of Supply) And profit increases (this is what drives the Law of Supply) o Build other cost curves into graph to see profit graphically An important note:- Average Total Cost (ATC) = TC/Q- So, TC = ATC *Q- Just like Total Revenue (TR) = P*Qo In Summary… To maximize profits, a firm should choose the Q such that MR(Q) = MR(Q) In perfectly competitive industries, MR(Q) = P for any Q (because firms are price takers) So choose Q that, MC(Q) = Po However, even when firms choose the Q that maximizes profit, that doesn’t always mean that they’re making a positive profito When should a firm even bother entering a market? Profit > 0 if TR(Q*) > TC(Q*)- (where Q* is the point where P = MC(Q*)) P x Q -> TC(Q) = ATC x Q -> P > ATC P > ATC (Q*) P = MC(Q*) > ATC (Q*)- Recall that MC crosses at ATV at the minimum of ATC, so if MC = P > ATC,then we know that MC = P > min (ATC)- More general condition, o Firm will be profitable if P > min (ATC) - Breakeven Priceo P= min(ATC) is the breakeven price, because it is the price wherefirms will breakeven, earning an economic profit of exactly $0 o How much should a firm produce? Goal is to maximize profit Answer: Q where MC = MR Profit = Total Revenue – Total Cost = Price x Quantity – (Average Total Cost to produce x Quantity)- Average Total Cost curve = Total cost / Quantity - So, Total Cost = Average Total Cost x Quantity - Similar to, Total Revenue (TR) = Price x Quantity Short-run production - Assuming profit < 0, shut down immediately only if o Profit (Q =0) > Profit (Q =Q*) o TR(Q = 0) – TC(Q=0) > TR(Q =Q*)-TC(Q=Q*)o 0 – FC > (P x Q*) – [FC =VC(Q*)]o AVC(Q*) > P  VC(Q*) > TR o So shut down immediately if you can’t cover your variable costs o When is production profitable? Profit > 0 if TR(Q*) > TC(Q*) (where Q* is the point where P = MC(Q*))- P x Q > TC(Q*)- P > ATC(Q*)- P = MC(Q*) > ATC(Q*)o But recall that MC crosses ATC at the minimum of ATC, so if MC = P > ATC, then we will know that MC = P > min(ATC)o So a more general condition: a firm will be profitable if P > min(ATC)- Break-Even Priceo Because of this condition, we call P=min(ATC) the break-even price, because it’s the pricewhere firm’s will just break even, earning an (economic) profit of exactly $0  P > min(ATC)  Profits > $0  P < min(ATC)  Profits < $0  Shut down price- Shutdown price is P= min(AVC)o P > min (AVC)  stay open in short runo P < min (AVC)  shut down immediatelySo far –• How much should firms produce? – Q where MR=MC, which maximizes profits • When will maximized profits be profitable? – P >min (ATC) – So clearly a firm shouldn’t enter a market if it knows that it’s min(ATC) > P – Similarly, in the long run a firm should definitely exit the market if min(ATC) > P • What about the short-run? Should a firm exit immediately if unprofitable?  Recall that by “short-run” we just mean the period where a firm can’t adjust it’s fixed inputs (and therefore is forced to pay it’s fixed costs) o So in the short-run, a firm must pay the fixed cost – whether it shuts down or not o Assuming Profit < 0, shut down immediately only ifProfit(Q=0) > Profit(Q=Q*) o TR(Q=0)-TC(Q=0)>TR(Q=Q*)-TC(Q=Q*) 0 - FC > (P x Q*) – [FC + VC(Q*)] AVC(Q*) > PVC(Q*) > TR So shut down immediately if you can’t even cover your variable costs. Shut-down priceo Just like the break-even price, the shutdown price is P = min(AVC) P > min(AVC)  stay open in short run, close in long run P < min(AVC)  shut down immediately What do perfectly competitive markets look like in the long run?- Suppose all firms have the same sorts of costs.- Currently, firms in the market are making profits?- What happens when highest profit is negative?o Leave immediately?o Leave in the long