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Week 11 chapter notes

Economics for Management Studies
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Chapter 8 Profit Maximization and Competitive Supply Notes
8.1 Perfectly Competitive Markets
x model of perfect competition rests on 3 basic assumptions: (1) price taking, (2) product homogeneity, and (3) free entry and exit
x price taker Æ firm that has no influence over market price and thus takes the price as given
x in a perfectly competitive market, each consumer buys such a small proportion of total industry output that he or she has no
impact on the market price, and therefore takes the price as given as well
x when the products of all the firms in a market are perfectly substitutable with one another—that is, when they are homogenous—
no firm can raise the price of its product above the price of other firms without losing most or all of its business
x when products are heterogeneous, each firm has opportunity to raise its price above its competitors without losing all of its sales
x free entry (or exit) Æ condition under which there are no special costs that make it difficult for firm to enter (or exit) an industry
x as a result, buyers can easily switch from one supplier to another, and suppliers can easily enter or exit a market
8.2 Profit Maximization
Do Firms Maximize Profit?
x for smaller firms managed by their owners, profit is likely to dominate almost all decisions
x in larger firms, managers may make day-to-day decisions usually have little contact with the owners (i.e., the stockholders)
x as a result, owners cannot monitor the managers’ behaviour on a regular basis
x managers then have some leeway in how they run the firm and can deviate from profit-maximizing behaviour
x managers may be more concerned with such goals as revenue maximization, revenue growth, or the payment of dividends
x they might also be overly concerned with the firm’s short-term profit (perhaps to earn a promotion or a large bonus) at the
expense of is longer-run profit, even though long-run profit maximization better serves the interests of the stockholders
Alternative Forms of Organization
x some forms of organizations have objectives that are quite different from profit maximization
x cooperative Æ association of businesses or people jointly owned and operated by members for mutual benefit
8.3 Marginal Revenue, Marginal Cost, and Profit Maximization
x profit Æ difference between total revenue and total cost
x marginal revenue Æ change in revenue resulting from a one-unit increase in output
x (q) = R(q) – C(q), which is maximized at ¨ / ¨q = 0: ¨/ ¨q = ¨R / ¨q – ¨C / ¨q = 0
x ¨ / ¨q is marginal revenue (MR) and ¨C / ¨q is marginal cost MC Æ MR – MC = 0 Æ MR(q) = MC(q)
Demand and Marginal Revenue for a Competitive Firm
x because each firm in a competitive industry sells only a small fraction of the entire industry output, how much output the firm
decides to sell will have no effect on the market price of the product
x the demand curve d facing an individual firm in a competitive market is both its average revenue curve and its MR curve
x along this demand curve, marginal revenue, average revenue, and price are all equal
Profit Maximization by a Competitive Firm
x because the demand curve facing a competitive firm is horizontal, so that MR = P, the general rule for profit maximization that
applies to any firm can be simplified to MC(q) = MR = P
8.4 Choosing Output in the Short Run
Short-Run Profit Maximization by a Competitive Firm
x marginal revenue equals marginal cost at a point at which the marginal cost curve is rising
x this is very important because it applies to the output decisions of firms in markets that may or may not be perfectly competitive
x output rule: if a firm is producing any output, it should produce at the level at which marginal revenue equals marginal cost
x shut-down rule: firm should shut down if price of the product is less than the AVC of production at the profit-maximizing output
8.5 The Competitive Firm’s Short-Run Supply Curve
x the firm’s supply curve is the portion of the marginal cost curve for which marginal cost is greater than average variable cost
x short-run supply curves for competitive firms slope upward for the same reason that marginal cost increases—the presence of
diminishing marginal returns to one or more factors of production
x as a result, an increase in the market price will induce those firms already in the market to increase the quantities they produce
x higher price makes additional production profitable and increases firm’s total profit as it applies to all units that firm produces
The Firm’s Response to an Input Price Change
x when the price of its product changes, the firm changes its output level to ensure that MC of production remains equal to price
x often, however, the product price changes at the same time that the prices of inputs change
8.6 The Short-Run Market Supply Curve
x the SR market supply curve shows the amount of output that the industry will produce in the SR for every possible price
x the industry’s output is the sum of the quantities supplied by all of its individual firms
x therefore, the market supply curve can be obtained by adding the supply curves of each of these firms
Elasticity of Market Supply
x unfortunately, finding the industry supply curve is not always as simple as adding up a set of individual supply curves
x as price rises, all firms in the industry expand their output
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