Managerial Economics

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Readings
Readings
Baye 6th edition or 7th edition, Chapter 8
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Overview
Overview
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Overview
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When Markets are Competitive
When Markets are Competitive
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When Markets are Competitive

• Overview
• When Markets are Competitive prices are outside
  of everyones control. Free entry into the
  industry adjusts those prices so long-run
  economic profits are zero. So, avoid
  competition.

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When Markets are Competitive

• Perfect Competition Environment
• Many buyers and producer-sellers.
• Homogeneous (perfectly substitutable) product.
• Example Apples from a variety of producers.
  --- Other examples?
• Perfect product information for both buyers and
  producer-sellers.
• No transaction costs.
• Free exit from the industry at any time.
• Free entry into the industry in the long run.
• You can change capital in the long run.
• So free entry means you can enter if you have the
  capital.

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When Markets are Competitive

• Preview of Perfect Competition Implications
• What effect did cancer have on the cigarette
  industry?
• Demand down, so price, quantity, and profit down
  (according to demand-supply analysis).
• But, profit down makes some producers quit.
• As some producers quit, industry supply down.
• As industry supply down, price and profit start
  back up.
• Adjustment continues until producers stop
  leaving, which means profits have to be back to
  where they started.
• Remaining producers thus regain profits in the
  long run.

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When Markets are Competitive

• Preview of Perfect Competition Implications
• General implications
• Firms are price takers
• P Competitors price
• MR P (since R P x Q, with P constant)
• In the short-run, firms may earn profits or
  losses (negative profits).
• Entry (if short-run profits are positive) and
  exit (if negative) forces long-run profits to
  zero.

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When Markets are Competitive

• Since few producers are perfectly competitive,
  why learn about perfect competition?
• Many small businesses are almost perfectly
  competitive.
• We could study them as monopolistic competitors,
  but the predictions would be almost like the
  businesses were perfect competitors.
• Gives an extreme environment to compare with
  monopolies.
• Illuminates the danger of competition to
  managers, and the importance of product
  differentiation to reduce competition.
• Chevron with Techron (an additive for
  cleanliness)
• Standard Oil Put a tiger in your tank
• Other examples?

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Setting Optimal Price and Quantity
Setting Optimal Price and Quantity
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OverviewSetting Optimal Price and Quantity to
maximize profit starts with price matching the
competition, then quantity where marginal cost
equals price provided the firm produces
anything at all.
Setting Optimal Price and Quantity
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Setting Price to Match the Competition
Setting Optimal Price and Quantity
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Setting Optimal Price and Quantity

• Setting Quantity
• General rule, set Q where MC(Q) MR(Q).
• Since, MR(Q) constant P, equate MC(Q) P to
  set Q.
• Calculating Profit
• P P x Q C(Q) (P C(Q)/Q) x Q (P ATC)
  x Q.

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Setting Optimal Price and Quantity
Setting Quantity and Calculating Profit
Profit (Pe - ATC) ? Qf
Pe Df MR
Pe
ATC
Qf
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Setting Optimal Price and Quantity

• A Numerical Example
• Given
• Competitors Price 10
• C(Q) 5 Q2
• Optimal Price?
• P10
• Optimal Output?
• MR P 10 and MC 2Q
• Set 2Q 10
• Q 5 units
• Optimal Profit?
• PQ - C(Q) (10)(5) - (5 52) 20

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Entry and Exit
Entry and Exit
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Overview Entry and Exit in an industry are
determined by profits. Positive profit causes
entry, slightly-negative profit causes exit in
the long run, and significantly-negative profit
causes exit in the short run.
Entry and Exit
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Should this Firm Sustain Short Run Losses or Shut
Down?
Entry and Exit
Profit (Pe - ATC) ? Qf lt 0
ATC
ATC
Pe Df MR
Pe
Qf
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Entry and Exit

• Shutdown Decision Rule
• A profit-maximizing firm should continue to
  operate (sustain short-run losses) if its
  operating loss is less than its fixed costs
  (really sunk cost), since fixed cost is the loss
  if shut down.
• Operating loss P PQ TC gt -FC, or PQ gt TC FC
  VC.
• P gt VC/Q AVC.
• Decision rule (if you expect current conditions
  to persist)
• Continue operating as long as P gt AVC.
• On graph, P gt min AVC.
• 9/11 made ATA bankrupt years later.
• Bankruptcy throughout a recession (not all at
  once).
• Operate or not (it does not matter) if P min
  AVC
• Immediate shut down if P lt AVC.
• On graph, P lt min AVC.

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Firms Short-Run Supply CurveProfit maximization
MC P and the shutdown rule imply the firms
short-run (FC gt 0) supply is MC above Min AVC.
Entry and Exit
P min AVC
Qf
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WorldCom files largest bankruptcy ever Nation's
No. 2 long-distance company in Chapter 11 --
largest with 107 billion in assets.July 22,
2002 1035 AM EDT By Luisa Beltran, CNN/Money
staff writerNEW YORK (CNN/Money) - WorldCom,
the nation's No. 2 long-distance phone company,
filed for Chapter 11 bankruptcy protection late
Sunday, nearly one month after it revealed that
it had improperly booked 3.8 billion in
expenses. WorldCom, crushed by its 41 billion
debt load, made its filing in the Southern
District of New York. With 107 billion in
assets, WorldCom's bankruptcy is the largest in
United States history, dwarfing that of Enron
Corp. The Houston-based energy trader listed
63.4 billion in assets when it filed Chapter 11
late last year. WorldCom's non-U.S. units were
not included in the filing. Bankruptcy had long
been expected for WorldCom (P gt AVC).
Entry and Exit
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Entry and Exit

• Short-Run Market Supply Curve
• The number of firms is fixed in the short run
  (because capital is fixed).
• The market supply curve is the horizontal
  summation of each individual firms supply at
  each price.

Market
Firm 1
Firm 2
P
P
P
15
5
Q
Q
Q
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Entry and Exit

• Long Run Adjustments if profits are positive?
• If firms are price takers but there are barriers
  to entry, profits will persist.
• If the industry is perfectly competitive, not
  only are firms price takers but there is free
  entry into the industry.
• Firms producing clones enter the market if
  profits are positive.

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Effect of Entry on Price?
Entry and Exit
S
Entry
Pe
Df
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Entry and Exit
Effect of Entry on Firms Price, Output, and
Profit? Entry continues until P PQ C 0,
meaning P C/Q AC, or P min AC.
Pe
Df
Df
Pe
Qf
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Entry and Exit

• Summary
• Short run profits lead to entry.
• Entry increases market supply, drives down the
  market price, increases the market quantity.
• Lower price means lower quantity supplied by each
  firm.
• Profit and price adjustment continues until the
  long run, where profits are zero.

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Entry and Exit

• Features of Competitive Equilibrium
• P MC
• The one and only socially-efficient output.
• For example, P 2 and MC 1 for candy is
  socially inefficient.
• There is some consumer willing to buy another
  candy for 2.
• There is a firm that can produce and distribute
  another candy for 1.
• Society would be better off is we changed plans
  and the firm produced and sold the extra candy
  for 1.50.
• The consumer gains .50 surplus the producer,
  .50 surplus.

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Entry and Exit

• Features of Long Run Competitive Equilibrium
• P minimum AC
• Price depends solely on cost.
• Why does a Mercedes cost more to consumers than a
  Honda?
• Any long-run difference in price is from a
  difference in production cost.

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Review Questions

• Review Questions
• You should try to answer some of the review
  questions (see the online syllabus) before the
  next class.
• You will not turn in your answers, but students
  may request to discuss their answers to begin the
  next class.
• Your upcoming Exam 1 and cumulative Final Exam
  will contain some similar questions, so you
  should eventually consider every review question
  before taking your exams.

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End of Lesson I.8
BA 445
Managerial
Economics