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Perfect Competition: Firm Output Decisions and Shutdown Costs
Dive into perfect competition and firm output decisions. Understand shutdown costs, profit maximization, and market dynamics. Master key economic concepts for competitive markets and business strategies.

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Now Playing:Perfect competition firms output decisions – Example 0a
Intros
  1. Firm's Output Decisions Overview:
  2. Firm's Output Decisions Overview:
    Total Revenue & Total Cost Curves
    • 2 ways for markets to maximize profit
    • Low output level  \, →  \, economic loss
    • High output level  \, →  \, economic loss
    • Intermediate output level  \, →  \, economic profits
    • Find the output with the biggest gap
  3. Firm's Output Decisions Overview:
    MC = MR
    • Profit maximized when MC = MR
    • MR > MC, economic profit  ↑ \, \uparrow \, when output  ↑ \, \uparrow \,
    • MR < MC, economic profit  ↓ \, \downarrow \, when output  ↑ \, \uparrow \,
    • MR = MC, economic profit  ↓ \, \downarrow \, when output  ↑ \, \uparrow \, or  ↓ \, \downarrow \,
Examples
  1. Maximizing Economic Profit, Analyzing Firm Operation, & Graphing Firm Supply Curves
    Use the following table to answer the questions

    Output

    Total Cost

    0

    5

    1

    10

    2

    13

    3

    18

    4

    25

    5

    34

    1. Calculate the profit-maximizing output and economic profit if the market price is $7.

    2. What is the shutdown point?

    3. What is the economic loss if the firm shuts down temporarily?

Perfect competition definitions
Jump to:NotesConceptExampleFAQsPrerequisites
Notes

There are 2 ways for firms to maximize profits:
  1. Examine the Total Revenue & Total Cost curves
  2. Find the output of when MR = MC

Total Revenue & Total Cost Curves

When examining the total revenue and total cost curves, we want to see which outputs give economic loss, and economic profit.


Total revenue & total cost curve

When TR < TC, when we have an economic loss. This happens at low and high levels of output production.


When TR = TC, we gain no profit and no loss. Then happens when the curves intersect.


When TR > TC, we gain economic profit. This happens at intermediate levels of output production.


Goal: Find an intermediate level of output that maximizes profit. In other words, find the biggest gap between TR & TC!


Note: We can also graph the economic profit curve (P = TR - TC), and find the point with the highest economic profit!


Profit maximization curve

MC = MR

Recall that the marginal revenue (firms demand curve) is horizontal.


In addition, the marginal cost decreases as output increases in the beginning, and then increases afterwards.


Therefore, we get the following graph.


Profit maximization curve

If MR > MC, economic profit increases as output increases.


If MR < MC, economic profit decreases as output increases.


If MR < MC, economic profit does not change if output increases or decreases. Profit is maximized here.



A Firms Decision to Shutdown

To see if a firm should stay open or shut down, we need to know how to calculate the economic loss of a firm.

Economic Loss = TFC + TVC - TR
= TFC + (AVC x q) - (p x q)
= TFC + (AVC - p) x q

When the firm decides to shutdown, then q = 0, and the economic loss is TFC. If the firm stay open, then q > 0, and the firm would have to pay both TFC and TVC.


The firm should stay open when AVC < p .


The firm should shut down when AVC > p .


The firm is indifferent about staying open and shutting down when AVC = p . This is also known as the shutdown point.



Note: Graphically, the shutting down is at the minimum of the AVC curve and intersects the MC curve.


Shutdown point curve

Firms Supply Curve

A firms supply curve shows the firms profit-maximizing output as the market price varies.


When the market price varies, the MR  \, shifts, causing the intersection of MR = MC  \, to change. All the intersection points create the firms supply curve.


Firm's supply curve shutdown point

Note: The firms supply curve starts at the shutdown point because thats when the firm starts producing output to reduce economic loss or gain profit.

Concept

Introduction to Perfect Competition Firm's Output Decisions

Welcome to our exploration of perfect competition and firm's output decisions! This fundamental concept in economics is crucial for understanding how businesses operate in highly competitive markets. Our introduction video sets the stage for a deep dive into this topic, providing you with a solid foundation. In perfect competition, firms are price takers, meaning they can't influence market prices. Instead, they focus on optimizing their output to maximize profits. We'll examine how firms make these critical decisions, balancing marginal revenue and marginal cost. You'll learn about the profit maximization rule and how it guides firms in determining their ideal production levels. As we progress, we'll also discuss the short-run and long-run implications of perfect competition on firm behavior. This knowledge is essential for grasping market dynamics and business strategies in competitive environments. Let's embark on this exciting journey to unravel the intricacies of perfect competition and firm decision-making!

Example

Firm's Output Decisions Overview: Total Revenue & Total Cost Curves

  • 2 ways for markets to maximize profit
  • Low output level economic loss
  • High output level economic loss
  • Intermediate output level economic profits
  • Find the output with the biggest gap

Step 1: Introduction to Perfect Competition and Profit Maximization

In a perfectly competitive market, firms aim to maximize their profit. There are two primary methods to achieve this goal. The first method involves examining the total revenue and total cost curves, while the second method focuses on finding the output level where marginal revenue equals marginal cost. This guide will delve into the first method in detail.

Step 2: Understanding Total Revenue and Total Cost Curves

To maximize profit, firms need to analyze the total revenue and total cost curves. The total revenue curve is typically a straight line, while the total cost curve is more complex, often resembling a squiggly line. By graphing these curves, firms can identify different output levels and their corresponding economic outcomes.

Step 3: Identifying Economic Loss at Low and High Output Levels

When the total revenue is less than the total cost, firms experience an economic loss. This scenario usually occurs at low and high levels of output production. At low output levels, the cost of production exceeds the revenue generated, leading to a loss. Similarly, at high output levels, the increased costs outweigh the revenue, resulting in another economic loss.

Step 4: Recognizing Economic Profit at Intermediate Output Levels

Economic profit occurs when the total revenue exceeds the total cost. This typically happens at intermediate levels of output production. By producing at these levels, firms can ensure that their revenue surpasses their costs, leading to economic profit. The goal is to find the output level within this range that maximizes the profit.

Step 5: Finding the Output with the Biggest Gap

To maximize profit, firms need to identify the output level where the gap between total revenue and total cost is the largest. This gap represents the maximum economic profit. By graphing the total revenue and total cost curves, firms can visually determine the point where this gap is the widest.

Step 6: Graphing the Economic Profit Curve

Another useful tool is the economic profit curve, which can be derived by subtracting the total cost curve from the total revenue curve. This curve typically resembles an upside-down U shape. The peak of this curve represents the output level that maximizes profit. By identifying this point, firms can determine the optimal output level for profit maximization.

Step 7: Conclusion and Practical Application

In summary, firms in a perfectly competitive market can maximize their profit by analyzing the total revenue and total cost curves. By identifying the output levels that lead to economic loss and profit, and finding the point with the largest gap between revenue and cost, firms can determine the optimal production level. Additionally, graphing the economic profit curve provides a clear visual representation of the profit-maximizing output level.

FAQs

  1. What happens if a firm shuts down in the short run?

    When a firm shuts down in the short run, it temporarily ceases production but retains its fixed assets. The firm stops incurring variable costs but continues to pay fixed costs. This decision is made when the market price falls below the average variable cost, making it more economical to halt production than to operate at a loss.

  2. What costs do firms that shut down in the short run still have to pay?

    Firms that shut down in the short run still have to pay their fixed costs. These typically include rent, property taxes, insurance, loan payments, and salaries for essential personnel. Variable costs, such as raw materials and hourly wages, are avoided during the shutdown period.

  3. What does a firm that exits the market have to pay?

    When a firm exits the market completely (long-run decision), it generally doesn't have ongoing costs. However, it may incur exit costs such as contract termination fees, severance payments to employees, and costs associated with liquidating assets. Any remaining debt obligations must also be settled.

  4. How do firms in competitive markets determine their optimal output level?

    Firms in competitive markets determine their optimal output level by producing where marginal cost (MC) equals the market price (P), which is also equal to marginal revenue (MR) in perfect competition. This point maximizes profits or minimizes losses. If P > MC, the firm should increase production; if P < MC, it should decrease production.

  5. What is the difference between a firm's short-run and long-run supply curve in perfect competition?

    The short-run supply curve in perfect competition is the portion of the marginal cost curve above the average variable cost curve. It reflects the firm's output decisions given fixed factors of production. The long-run supply curve, however, is perfectly elastic (horizontal) at the minimum of the long-run average cost curve, as firms can adjust all factors of production and enter or exit the market freely.

Prerequisites

Understanding the concept of perfect competition firm's output decisions is crucial for students of economics and business. While there are no specific prerequisite topics provided for this subject, it's important to recognize that a strong foundation in basic economic principles is essential for grasping this more advanced concept.

To fully comprehend perfect competition firm's output decisions, students should have a solid understanding of supply and demand dynamics, market structures, and basic microeconomic principles. These fundamental concepts serve as building blocks for more complex economic theories and models.

One key aspect to consider is the nature of perfect competition itself. In a perfectly competitive market, firms are price takers, meaning they have no control over the market price. This concept is crucial for understanding how firms make output decisions in such an environment. Students should be familiar with the characteristics of perfect competition, including a large number of buyers and sellers, homogeneous products, and free entry and exit from the market.

Another important area to grasp is the concept of marginal analysis. Firms in perfect competition make output decisions based on marginal costs and marginal revenues. Understanding how to calculate and interpret these marginal values is essential for determining the profit-maximizing output level.

Cost analysis is also a critical component of this topic. Students should be comfortable with various cost concepts, such as fixed costs, variable costs, average costs, and total costs. These cost structures play a significant role in a firm's decision-making process regarding output levels.

Furthermore, knowledge of profit maximization strategies is vital. Firms in perfect competition aim to maximize their profits, and understanding how to determine the point where marginal revenue equals marginal cost is key to this process.

While specific prerequisite topics are not provided, students should ensure they have a strong grasp of these fundamental economic concepts before delving into the intricacies of perfect competition firm's output decisions. A solid foundation in these areas will greatly enhance their ability to analyze and understand the decision-making processes of firms in perfectly competitive markets.

By building upon these core economic principles, students will be better equipped to explore the nuances of perfect competition and how firms navigate this unique market structure to make informed output decisions. This comprehensive understanding will not only aid in academic success but also provide valuable insights into real-world economic scenarios and business strategies.