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Shut down point and profit

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  • These revenue concepts are analogous to the cost concepts (TC, ATC, MC) in the previous chapter.
  • This slide is similar to Figure 1 in the chapter. I’ve omitted the AVC and ATC curves (which appear in Figure 1 in the chapter) because they are not needed at this point.
  • The shutdown rule, in plain English, says:
    If the cost of shutting down is less than the benefit, the firm should shut down.
  • In edit mode, it looks like the text boxes are on top of each other. But in presentation mode, the text boxes display only one at a time.
  • The decision rule for whether to exit says:
    If the cost of exiting is greater than the benefit, the firm should exit.
  • Similarly, a prospective entrant compares the benefits of entering the market (TR) with the costs (TC), and enters if the benefits exceed the costs.
  • Rather than tell students that profit equals (P – ATC) x Q, this exercise requires students to figure it out for themselves.
    If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file.
  • The height of the rectangle is P – ATC, profit per unit.
    The width of the rectangle is Q, the number of units.
    The area of the rectangle
    = height x width
    = (profit per unit) x (number of units)
    = total profit.
  • Students that didn’t figure out the answer to the previous exercise should be able to get this one.
    If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file.
    Note that the statement “assuming AVC < $3” is needed to prevent shut-down, i.e. to insure that the firm produces Q=30 instead of Q=0.
  • The height of the rectangle is ATC – P, loss per unit.
    The width of the rectangle is Q, the number of units.
    The area of the rectangle
    = height x width
    = (loss per unit) x (number of units)
    = total loss.

Transcript

  • 1. Bellringer Mankiw Ch 14 Write the fixed and variable costs to Cisco, the company that makes this good.
  • 2. Economic Competition • 4 basic market types: – Perfect Competition – Monopolistic Competition – Oligopoly – Monopoly • Measures price/nonprice competition, and product differentiation
  • 3. The Revenue of a Competitive Firm • Total revenue (TR) TR = P x Q • Average revenue (AR) TR =P AR = Q • Marginal revenue (MR): The change in TR from ∆TR MR = ∆Q FIRMS IN COMPETITIVE MARKETS selling one more unit. 3
  • 4. MR = P for a Competitive Firm • A competitive firm can keep increasing its output without affecting the market price. • So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for MR = P is only true for firms in competitive markets. firms in competitive markets. FIRMS IN COMPETITIVE MARKETS 4
  • 5. Have you ever seen this?
  • 6. MC and the Firm’s Supply Decision Rule: MR = MC at the profit-maximizing Q. At Qa, MC < MR. Costs So, increase Q to raise profit. MC At Qb, MC > MR. So, reduce Q to raise profit. MR P1 At Q1, MC = MR. Changing Q would lower profit. FIRMS IN COMPETITIVE MARKETS Qa Q1 Qb Q 6
  • 7. MC and the Firm’s Supply Decision If price rises to P2, Costs then the profitmaximizing quantity rises to Q2. P MC MR2 2 The MC curve determines the firm’s Q at any price. MR P1 the MC curve is the FIRMS IN COMPETITIVE MARKETS firm’s supply curve. Q1 Q2 Q 7
  • 8. Shutdown vs. Exit • Shutdown: A short-run decision not to produce anything because of market conditions. • Exit: A long-run decision to leave the market. • A key difference: – If shut down in SR, must still pay FC. – If exit in LR, zero costs. FIRMS IN COMPETITIVE MARKETS 8
  • 9. A Firm’s Short-run Decision to Shut Down • Cost of shutting down: revenue loss = TR • Benefit of shutting down: cost savings = VC (firm must still pay FC) • So, shut down if TR < VC • Divide both sides by Q: TR/Q < VC/Q • So, firm’s decision rule is: Shut down if P < AVC FIRMS IN COMPETITIVE MARKETS 9
  • 10. Cotton PEST Up Demand down
  • 11. A Competitive Firm’s SR Supply Curve The firm’s SR supply curve is the portion of its MC curve above AVC. Costs If P > AVC, then firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0). FIRMS IN COMPETITIVE MARKETS MC ATC AVC Q 11
  • 12. Sunk Costs • Sunk cost: a cost that has already been committed and cannot be recovered • Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. • FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. • So, FC should not matter in the decision to shut down. 12
  • 13. A Firm’s Long-Run Decision to Exit • Cost of exiting the market: revenue loss = TR • Benefit of exiting the market: cost savings = TC (zero FC in the long run) • So, firm exits if TR < TC • Divide both sides by Q to write the firm’s decision rule as: Exit if P < ATC FIRMS IN COMPETITIVE MARKETS 13
  • 14. A New Firm’s Decision to Enter Market • In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. Enter if P > ATC • Divide both sides by Q to express the firm’s entry decision as: FIRMS IN COMPETITIVE MARKETS 14
  • 15. Draw side by side graphs on the board Klein
  • 16. The Competitive Firm’s Supply Curve The firm’s LR supply curve is the portion of its MC curve above LRATC. Costs MC LRATC Q FIRMS IN COMPETITIVE MARKETS 16
  • 17. A C T I V E L E A R N I N G 2 Identifying a firm’s profit Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. A competitive firm Costs, P MC MR ATC P = $10 $6 50 Q 17
  • 18. A C T I V E L E A R N I N G 2 Answers A competitive firm Costs, P MC Profit per unit = P – ATC = $10 – 6 = $4 MR ATC P = $10 Total profit = (P – ATC) x Q = $4 x 50 = $200 profit $6 50 Q 18
  • 19. A C T I V E L E A R N I N G 3 Identifying a firm’s loss Determine this firm’s total loss, assuming AVC < $3. Identify the area on the graph that represents the firm’s loss. A competitive firm Costs, P MC ATC $5 MR P = $3 30 Q 19
  • 20. A C T I V E L E A R N I N G 3 Answers A competitive firm Costs, P MC Total loss = (ATC – P) x Q = $2 x 30 = $60 ATC $5 P = $3 loss loss per unit = $2 MR 30 Q 20
  • 21. http://www.reffonomics.com/TRB/chapter9/perfectcompetitioninteractivegrapheverything 2.swf
  • 22. Flip camera reading Person 1: reads part 1 aloud Person 2: Why didn’t Cisco think much of the Flip camera? Person 3: Why is the shut down surprising? Person 1: Was the flip making a profit for Cisco? Person 2: reads part 2 aloud Person 3: Why was the Flip a successful product? Person 1: Why do you think Cisco shut down rather than sell the division? Person 2: In the long run, why do you think Cisco shutdown the Flip camera? Person 3: reads part 3 aloud