Lecture Outline - Costs and Profit Maximization under Competition1. What are the characteristics of a perfectly competitive market?1.Large Number of sellers2.Large # of buyers. Any one buyer of seller cannot influence the market price3. Each seller provides a similar product4. Easy to enter into the market. (i.e. no significant barriers to entry)5. (Demand curve is exactly equal to the market price) - not a real characteristic just what they stirve fora. What is the goal (i.e. objective) of a competitive firm? How is profit calculated?i. Goal is to maximize profit. Max profit = Total revenue-total costb. What does it mean to be a “price taker?” i. No one has influence over the price. Price is determined in the market. Firms and consumers are price takersc. What is the difference between the market demand curve and the demand curve faced by a perfectly competitive firm? Why is the demand curve faced by a per-fectly competitive firm perfectly elastic?d. What is marginal revenue (MR)? How is it calculated? What is the relationship between a perfectly competitive firm’s MR curve and its demand curve? What is the relationship between the market price and a perfectly competitive firm’s MR?i. MR is change in Total Revenue/Change in outputii. For perfectly competitive firm, marginal revenue = market price and marginal revenue curve overlaps with the per-fectly elastic demand curve.e. How is average revenue (AR) calculated? What is the relationship between AR and P?2. What is the difference between Accounting and Economic Profit? How is each calcu-lated? Which is greater? Why?a. What is an explicit cost? Implicit cost? Give an example of each.i. Explicit cost- costs which require a monetary paymentii. Implicit costs - costs that aren't obvious, forgone interest, opportunity cost,lost income1b. What are accounting costs? Economic costs? What is the relationship between the two?i. Economic costs are explicit + implicit costsii. Accounting costs=explicit costsiii. Accounting profit = Revenue - Accounting costsiv. Economic profit = Revenue - Economic costsv. Economic costs will always exceed accounting costs. When she refers to costs = economic costs. When she refers to profit = economic profit.3. What are the two conditions that differentiate the short run (SR) from the long run (LR)?•Short Run = at least one fixed input (one that will not change as you produce more out-put), No entry of firms (market price will not change)4. Short-run costsa. What is a fixed cost (FC)? Variable cost (VC)? Fixed costs - Do not vary with the quantity of output produced (pizza oven, coffeemaker) Only fixed costs are incurred if there is not outpurVariable costs - vary with the quantity of output produced (ex, flour, sauce, cheese, labor)As ouput increases, variable costs increaseTotal Costs = FC+VCb. How are total costs (TC) calculated? Why are TC > 0 if we do not produce any output?i. Total Costs = FC+VCii. TC is greater than 0 because of fixed costs which do not change, Differ-ence between total costs and Variable costs = fixed costsc. How do FC, VC, and TC vary as output varies? Draw a graph of the FC, VC, andTC curves.2d.e. How do you calculate average fixed cost (AFC)? Average variable cost (AVC)? Average total cost (AC)? How do these costs vary as output varies? Draw a graph of the AFC, AVC, and AC curves.i. AFC = Fixed Cost/Quantityii. AFC falls as Quantity rises. Firm is spreading its fixed costs over a larger and larger number of units/ Spreading out our overheadiii. AFC will fall as we produce more outputiv. Average Variable Costs = Variable Costs/Quantityv. As Quantity rises, AVC may fall initially but in most cases, AVC will eventually rise as output risesvi. Average (total) Costs = Total cost/quantityvii. AC = AFC +AVCf. Explain why the AC curve is u-shaped.i. Will initially decrease and then increaseii. U shaped because as quantity rises, initially AFC pulls down AC. Eventu-ally rises because AVC pulls AC upiii. Average cost curve is overcome by Average variable Cost curve event though Average fixed cost curve is gradually falling at a very small rate.g. Identify two ways to calculate marginal cost (MC).i. Marginal cost = change in total cost from producing an additional unit of output. MC = Change in TC/Change in Quantity3ii. MC = Change in FC/Change in quantity + Change in VC/Change in Quan-tityiii. MC= Change in VC/Change in Quantityh. Explain why the MC curve intersects the AC curve at its minimum. What hap-pens to AC whenever MC < AC for a given quantity? What happens to AC when-ever MC > AC for a given quantity?i. Whenever marginal cost is less than average costs then average cost is fallingii. If MC is greater than Average costs, average cost goes up. If on the marginthe cost of producing another unit exceed current average, average will start to riseiii. Marginal Cost will cross the AC curve at the Ac curve’s minimumiv.i. Consider this statement: The MC of the 3rd unit is $10, but the AC of the third unitis $15. Explain what it means.5. How will a perfectly competitive firm choose the quantity of output to produce? What is the relationship between MR and MC at this quantity? How will it choose the price to charge? How does the profit-maximizing price compare to MR and MC?a. Model the profit-maximizing decision on a graph by drawing the firm’s D, MC, and MR curves. Identify the profit-maximizing quantity and price on your graph.b. What is marginal profit? Identify two ways to calculate marginal profit.4c. What happens to total profit if marginal profit > 0? What happens to total profit ifmarginal profit < 0?d. Use a graph to identify: TR, TC, the firm’s profit (or loss).6. Why will a firm produce even if it is making an economic loss? Under what condition will the firm choose to not operate (i.e. shutdown) in the short run? 7. What is the relationship between a firm’s MC curve and a firm’s supply curve?a. Explain how to derive the short run market supply curve in a competitive market from the MC curves of the individual firms.b. Will a firm ever produce on the downward sloping portion of its MC curve? Whyor why not?8. What makes the long run different from the short run? Name two characteristics of the long run.a. Under what condition will firms choose to enter an industry in the long run? When firms enter a market what happens to:i. The market priceii. The output of the firms that remain in the marketiii. The profit of the firms that