Managerial Economics Class 6: The University of British Columbia

Managerial Economics
Class 6
i. Review Questions
1. Comment on Market Structure (Section 7.5 in textbook.)
2. Perfect Competition (Chapter 8, Sections 8.1-8.2)
a) Short Run Profit Maximization
b) The Supply Curve
c) Comment on Long Run Competitive Equilibrium (8.3)
3. Consumer and Producer Surplus (8.4)
Readings: Chapters 8.1-8.2, 8.4
THE UNIVERSITY OF BRITISH COLUMBIA

Review: Clicker Question 1
Toyota is thinking of investing $1billion in R&D this year for a new

electric car. The investment is expected to increase future profits of
the firm by $100 million per year in perpetuity, starting next year.
a) The investment will put downward pressure on current profit.

b) The investment will put upward pressure on Toyota’s stock
price if the interest rate is 5%.
c) The investment has a negative PV if the interest rate is 5%.
d) The investment has a positive PV because a million dollars
every year forever is an infinite payoff.
e) a and b

Review: Clicker Question 2
Which statement about Canada’s business environment is correct?
a. Public sector enterprises such as BC Hydro are publicly traded.

b. Most large firms are corporations.
c. The agency problem is that corporations place too much
emphasis on maximizing profit.
d. To maximize profit a firm must choose output so that marginal
revenue exceeds marginal cost.
e. None of the above.

1. Market Structure
There are four main market structures. We will cover them

in the following order.
1. Perfect Competition
2. Monopoly
3. Oligopoly
4. Monopolistic Competition

2. Perfect Competition
Perfect competition is a market structure in which buyers and sellers
are price takers – they have no control over market price.
A perfectly competitive firm is a firm that is so small relative to the
market that it takes the market price as given: the firm is a price-
taker.
We often use the term “competitive” instead of “perfectly
competitive”.

Why Start with Perfect
Competition
Many markets can be reasonably approximated by this market

structure
It has desirable properties, so it is useful to compare other
market structures to competition
It is closely related to the model of supply and demand.

Characteristics of Perfect
Competition
The following characteristics or conditions lead to perfect competition
(i.e. to price-taking by firms).
a. Many small buyers and sellers.
b. Firms produce identical products.
c. Full information (buyers and sellers know what prices are available
in the market).
d. Transaction costs are very low.
e. Free entry and exit in the long run.
We will assume all of these conditions are present in perfect
competition.

a. Profit Maximization for a
Competitive Firm
Any firm maximizes profit where MR = MC.
What is MR for a perfectly competitive firm?
R = pq, but p is taken as “given” – a constant from the point of view of
the firm.
MR = dR/dq = p.
Therefore, the profit-maximizing condition is p = MC (or MC = p).
The firm chooses output so that marginal cost equals price.
Note that π = R – C = pq – C(q) = q(p – C/q) = (p – AC)q.
“Profit” refers to “above normal” profit. Normal profit is part of cost.

Clicker Question 3
Suppose a competitive firm faces a price of 100 for its product.

Suppose the firm’s total cost curve is C = 10 + 20q + 5q2 .
a. Fixed costs equal 20.

b. The profit maximizing quantity is less than 10.
c. The profit maximizing quantity equals 10.
d. The profit maximizing quantity exceeds 10.
e. a. and c.
THE UNIVERSITY OF BRITISH COLUMBIA 2 of 4

Profit Maximization
MC
The firm produces q* and
$
earns profit equal to the
area of the shaded region:
(p-AC)q* AC
e
p p = MR
AC (q*)
q* Units per period

The Shutdown decision for a
competitive firm
Suppose a firm has unavoidable fixed costs.

When should it shut down and when should it operate?
It should operate if p > AVC and shut down if p < AVC.

b. The Short Run Supply
Curve
In the short run firms cannot enter the market. They can shut
down (stop producing) but must still pay fixed costs.
Shifts in market price trace out a competitive firm's supply curve
The supply curve is MC above the minimum of the AVC curve
At each price, we find the output the firm wants to produce by

using the MC curve.

Illustrating a Firm’s Short
Run Supply Curve
p , $ per ton S
e4
8 p4
e3
AC
7 p3
AVC
e2
6 p2
e1
5 p1
MC
0 q1 = 50 q2 = 140 q3 = 215 q4 = 285

q, Thousand metric tons of lime per year
Short Run Market Supply with
n Identical Firms
The market supply curve is horizontal sum of the supply curves of all the
individual firms.
The maximum number of firms in a market, n, is fixed in SR
Market supply curve at any price is n times the supply of an individual

firm
The larger is n (more identical firms), the flatter (more elastic) the SR
market supply curve at each price.
The market supply curve shows the MC for any output level.
Note that MC must be the same for every firm because p = MC for every
firm.
c. Long Run (LR) Entry
The primary difference between the short run and the long run is that
entry can occur in the long run but not in the short run.
The LR market supply curve is based on the sum of individual firm supply
curves and on the effect of entry and exit.
If P > AC new firms enter. This puts downward pressure on price and
therefore moves price toward AC.
If P < AC some firms exit, which put upward pressure on price.
Only if P = AC is the market in long run equilibrium.

Long Run Equilibrium
Assume all firms are symmetric. Then,
In the long run, firms must operate where P = AC (due to free entry)
and
where P = MC (due to profit maximization).
This can only happen at the minimum of the AC curve, where

MC = AC = P.
If firms differ (have different average cost curves) the marginal firm must
satisfy P = AC. All profit-maximizing firms satisfy MR = MC.
AC includes “normal profit”. In long run equilibrium competitive firms

earn only “normal profits” no “excess” or “abnormal” profit.
Price is a Signal
Price acts as a signal to firms. In the short run an increase in
price is a signal to produce more – and the firm does.
A decrease in price is a signal to the firm to produce less and

possibly to shut down.
In the long run an increase in price acts a signal to enter. A low

price is a signal to exit.

3. Consumer and Producer Surplus
Competitive markets perform well. In order to see this it is

necessary to understand consumer and producer surplus.
a) Consumer surplus (CS) is a dollar measure of consumer welfare

or consumer benefit from a market.
b) Specifically, consumer surplus is defined as the monetary

difference between what a consumer is willing to pay for the
quantity of the good purchased and what the good actually costs.
c) In other words, it is a measure of how much more consumers

value a good than it costs them to buy it.

Consumer Surplus Cont’d
If, for example, a firm develops a new method that lowers the cost
of production, reducing the market price, we can value the benefit to
consumers by determining how much consumer surplus changes.
Similarly, we can use consumer surplus to assess the effects of

various government interventions in markets, like price controls.

David’s Willingness to Pay
David likes to read magazines.

For the first magazine per week, he would be willing to pay $5.
His willingness to pay is $4 for the second, $3 for the third, $2 for
the 4th, $1 for the 5th and nothing for anything more.
The price of magazines is $3.
What will David do and what is his consumer surplus?

Consumer Surplus Diagram
p, $ per magazine
a
David’s demand 5
curve is shown
b
by the blue 4
“step function”. CS1 = $2 CS2 = $1

c
3 Price = $3
David purchases
3 magazines and
2
his consumer
E 1 = $3 E 2 = $3 E 3 = $3
surplus is 3 Demand
1
0 1 2 3 4 5
q, Magazines per week
Consumer surplus is the area under the demand curve and above the price,
up to the quantity consumed.
Consumer Surplus with a
smooth demand curve
p, $ per
trading card
Consumer
surplus, CS
p1
Expenditure, E Demand
Marginal willingness to
pay for the last unit of output
q1 q
, Trading cards per year
Clicker Question 4
Suppose inverse demand is given by P = 30 – 2Q. Suppose price

is 10. Which of the following statements is true?
a. Consumer surplus is less than 100.

b. Consumer surplus equals 100.
c. Consumer surplus exceeds 100.
d. Consumer surplus would decrease if price fell.
e. None of the above.

Producer Surplus
Producer surplus (PS) is the difference between the amount for which a
good sells and the minimum amount needed to induce producers to
provide the good.
PS for a firm is the area above the marginal cost curve and below the
price up to the amount sold.
The MC is $1 for the 1st

unit, $2 for the 2nd, etc.
and the price is $4. PS is
the green area: $6.

Summary
1. Perfect Competition: Price Taking
2. Profit Maximization for a Competitive Firm: P = MC
3. The supply curve for a competitive firm is the marginal cost curve
(above AVC).
4. Under perfect competition in the long run, free entry forces firms to
produce at the minimum point of the AC curve where P = AC = MC.
5. Consumer Surplus (CS) is a measure of consumer benefits from a
market.
6. Producer Surplus (PS) is a measure of producer benefits from a
market.

Managerial Economics Class 6: The University of British Columbia

Uploaded by

Copyright:

Available Formats

Managerial Economics Class 6: The University of British Columbia

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Managerial Economics Class 6: The University of British Columbia

Uploaded by

Copyright:

Available Formats

Managerial Economics

Readings: Chapters 8.1-8.2, 8.4

THE UNIVERSITY OF BRITISH COLUMBIA

Toyota is thinking of investing $1billion in R&D this year for a new

a) The investment will put downward pressure on current profit.

THE UNIVERSITY OF BRITISH COLUMBIA

Which statement about Canada’s business environment is correct?

a. Public sector enterprises such as BC Hydro are publicly traded.

THE UNIVERSITY OF BRITISH COLUMBIA

There are four main market structures. We will cover them

THE UNIVERSITY OF BRITISH COLUMBIA

THE UNIVERSITY OF BRITISH COLUMBIA

Many markets can be reasonably approximated by this market

THE UNIVERSITY OF BRITISH COLUMBIA

THE UNIVERSITY OF BRITISH COLUMBIA

THE UNIVERSITY OF BRITISH COLUMBIA

Suppose a competitive firm faces a price of 100 for its product.

a. Fixed costs equal 20.

THE UNIVERSITY OF BRITISH COLUMBIA 2 of 4

q* Units per period

Suppose a firm has unavoidable fixed costs.

THE UNIVERSITY OF BRITISH COLUMBIA

Shifts in market price trace out a competitive firm's supply curve

The supply curve is MC above the minimum of the AVC curve

At each price, we find the output the firm wants to produce by

THE UNIVERSITY OF BRITISH COLUMBIA

0 q1 = 50 q2 = 140 q3 = 215 q4 = 285

The maximum number of firms in a market, n, is fixed in SR

Market supply curve at any price is n times the supply of an individual

THE UNIVERSITY OF BRITISH COLUMBIA

This can only happen at the minimum of the AC curve, where

AC includes “normal profit”. In long run equilibrium competitive firms

A decrease in price is a signal to the firm to produce less and

In the long run an increase in price acts a signal to enter. A low

THE UNIVERSITY OF BRITISH COLUMBIA 2 of 4

Competitive markets perform well. In order to see this it is

a) Consumer surplus (CS) is a dollar measure of consumer welfare

b) Specifically, consumer surplus is defined as the monetary

c) In other words, it is a measure of how much more consumers

THE UNIVERSITY OF BRITISH COLUMBIA

Similarly, we can use consumer surplus to assess the effects of

THE UNIVERSITY OF BRITISH COLUMBIA

David likes to read magazines.

THE UNIVERSITY OF BRITISH COLUMBIA

“step function”. CS1 = $2 CS2 = $1

Suppose inverse demand is given by P = 30 – 2Q. Suppose price

a. Consumer surplus is less than 100.

THE UNIVERSITY OF BRITISH COLUMBIA 2 of 4

The MC is $1 for the 1st

THE UNIVERSITY OF BRITISH COLUMBIA

THE UNIVERSITY OF BRITISH COLUMBIA

You might also like