Chapter 11:

MANAGERIAL DECISIONS IN COMPETITIVE MARKETS

Essential Concepts

1. 1Perfect competition occurs when a market possesses the following three characteristics:
i. Firms are price-takers because each firm produces only a very small portion of total
market or industry output.
ii. All firms in the market produce a homogeneous or perfectly standardized product.
iii. Entry into and exit from the market is unrestricted.
2. The demand curve facing a competitive price-taking firm is horizontal or perfectly elastic at
the price determined by the intersection of the market demand and supply curves. Since
marginal revenue equals price for a competitive firm, the demand curve is also
simultaneously the marginal revenue curve (i.e., D = MR). Price-taking firms can sell all they
want at the market price. Each additional unit of sales adds to total revenue an amount equal
to price.
Profit Maximization in the Short Run:
3. In the short run, the firm incurs fixed costs that are unavoidable – i.e., they must be paid even
if output is zero—and variable costs that can be avoided if the firm chooses to shut down.
4. Shut down refers to the decision in the short run to produce zero output, which means the
manager hires no variable inputs. The only costs incurred during shut down are the
unavoidable fixed costs (quasi-fixed costs are avoidable).
5. A manager makes two decisions in the short run: (1) whether to produce or shut down, and
(2) if the decision is to produce, how much to produce.
6. In making the decision to produce or shut down, the manager will consider only the
(avoidable) variable costs and will ignore fixed costs.
7. Profit margin is the difference between price and average total cost, which is equal to
average profit (or profit per unit), as long as every unit is sold for the same price:

8. The output level that maximizes profit margin is not the output level that maximizes profit.
For this reason, managers should ignore profit margin or profit per unit when making their
production decisions. See Figure 11.3 in the textbook for a numerical example that shows
why it is a mistake to maximize profit margin.
9. Break-even points are the output levels – there are usually two of these points—where price
equals average total cost, and thus profit equals zero at these points.
10. In the short run, the manager of a firm will choose to produce the output where P = SMC,
rather than shut down, as long as total revenue is greater than or equal to the firm’s total
avoidable cost or total variable cost ( ). Or, equivalently, a firm should produce as
Chapter 11: Managerial Decisions in Competitive Markets
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 long as price is greater than or equal to average variable cost ( ). If total revenue
cannot cover total avoidable cost, that is, if total revenue is less than total variable cost (or
equivalently, P < AVC), the manager will shut down and produce nothing, losing an amount
equal to total fixed costs.
11. Fixed costs are irrelevant in the production decision because the level of fixed cost has no
effect on either marginal cost or minimum average variable cost, and thus no effect on the
optimal level of output.
12. Sunk costs are irrelevant in the production decision because such costs are forever
unrecoverable, no matter what output decision is made, and so sunk costs cannot affect
current or future decisions.
13. Average costs are also irrelevant for production decisions. Only marginal cost matters when
finding the positive amount of output that maximizes profit. Technical note: AVC is not
employed to find the optimal output, but rather to make sure the optimal output is not zero
(i.e, whether to shut down or not).
14. Summary of the manager's output decision in the short-run:
i. Average variable cost tells whether to produce; the firm ceases to produce—shuts down
—if price falls below minimum AVC.

ii. Marginal cost tells how much to produce: if P minimum AVC, the firm produces the
output at which P = SMC.
iii. Average total cost tells how much profit or loss is made if the firm decides to produce;
profit equals the difference between P and ATC multiplied by the quantity produced and
sold.
15. The short-run supply curve for an individual price-taking firm is the portion of the firm’s
marginal cost curve above minimum average variable cost. For market prices less than
minimum average variable cost, quantity supplied is zero.
16. The short-run supply curve for a competitive industry can be obtained by horizontally
summing the supply curves of all the individual firms in the industry. Short-run industry
supply is always upward sloping, and supply prices along the industry supply curve give the
marginal costs of production for every firm contributing to industry supply.
17. Short-run producer surplus is the amount by which total revenue exceeds total variable cost
and equals the area above the short-run supply curve below market price over the range of
output supplied. Short-run producer surplus exceeds economic profit by the amount of total
fixed costs.
Profit Maximization in the Long Run:
18. In long-run competitive equilibrium, all firms are maximizing profit (P = LMC). Long-run
competitive equilibrium occurs because of the entry of new firms into the industry or the exit
of existing firms from the industry. The market adjusts so that P = LMC = LAC, which is at
the minimum point on LAC.
19. The long-run industry supply curve can be either flat (perfectly elastic) or upward sloping
depending upon whether the industry is a constant cost industry or an increasing cost
industry, respectively.
a. For a constant cost industry, as industry output expands, input prices remain constant,
and the minimum point on LAC is unchanged. Since long-run supply price equals
minimum LAC, the long-run industry supply curve is perfectly elastic (horizontal).
Chapter 11: Managerial Decisions in Competitive Markets
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 b. For an increasing cost industry, as industry output expands, input prices are bid up,
causing the minimum point on LAC to rise, and long-run supply price to rise. The long-
run industry supply curve for an increasing cost industry is upward sloping.
20. For both constant-cost and increasing-cost industries, long-run industry supply curves give
supply prices for various levels of industry output allowing the industry to reach long-run
competitive equilibrium. Thus, economic profit for every firm in the industry is zero at all
points on the long-run industry supply. Furthermore, long-run supply prices give both LACmin
and LMC for all firms in the industry.
21. Economic rent is a payment to the owner of a scarce, superior resource in excess of the
resource’s opportunity cost. Firms that employ such exceptionally productive resources earn
only a normal profit (economic profit is zero) in long-run competitive equilibrium because
the potential economic profit from employing a superior resource is paid to the resource as
rent.
22. As noted above, firms that employ exceptionally productive, superior resources earn zero
economic profit in long-run competitive equilibrium. In increasing industries, all long-run
producer surplus is paid to resource suppliers as economic rent. And, of course, for constant-
cost industries there is zero producer surplus (and zero rent) since industry supply is perfectly
horizontal.
Profit-Maximizing Input Usage:
23. Choosing either output or input usage to maximize profit leads to the same maximum profit
level. The profit-maximizing level of input usage produces exactly that level of output that
maximizes profit.
a. The marginal revenue product (MRP) of an additional unit of a variable input is the
additional revenue from hiring one more unit of the input. For the variable input labor:

When a manager chooses to produce rather than shut down (TR > TVC), the optimal level
of input usage is found by following this rule: If the marginal revenue product of an
additional unit of the input is greater (less) than the price of the input, then that unit
should (not) be hired. If the usage of the variable input varies continuously, the manager
should employ the amount of the input at which MRP = input price.
b. Average revenue product (ARP) is the average revenue per worker (ARP = TR/L). ARP
can be calculated as the product of price times the average product of labor:

A manager should shut down operation in the short-run if there is no level of input usage
for which ARP is greater than or equal to MRP. When ARP is less than MRP, total
revenue is less than total variable cost, and the manager minimizes losses in the short run
by shutting down.
Implementing the Profit-Maximizing Output Decision:
124. The following steps that use empirical estimates of price and costs can be
employed to find the profit-maximizing rate of production and the level of profit a
competitive firm will earn.
Step 1: Forecast the price of the product. Use the statistical techniques presented in
Chapter 7 to forecast the price of the product.

Chapter 11: Managerial Decisions in Competitive Markets

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 Step 2: Estimate average variable cost (AVC) and marginal cost (SMC). The cubic
specification is the appropriate form for estimating a family of short-run cost
curves:

and
Step 3: Check the shutdown rule. If P AVCmin, then the manager should produce. If P
< AVCmin, then the manager should shut down (i.e., Q* = 0).

Step 4: If P , find the output level where P = SMC. The profit-maximizing

output level occurs where P = SMC. To find the optimal level of output, set
forecasted price equal to estimated marginal cost and solve for Q*:

Step 5: Compute profit or loss. Once a manager determines how much to produce, the
calculation of total profit is a straightforward matter.

If , the firm shuts down, and profit is –TFC.

Answers to Applied Problems

1. The fact that the club closed implies that it incurred economic losses, i.e., implicit costs must have
exceeded $100,000. Assuming that the opportunity cost of capital is the only omitted implicit cost,
the owner must have alternative investment opportunities with an expected rate of return greater than
10%.

2. a. – c. Your spreadsheet when price is $190 per unit should look like:

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13)
PROFMARG
AVGPROF
PROF

Q TC TFC TVC AFC AVC ATC SMC TR MR

0 5000 5000 0 xx xx xx xx 0 xx -5000 xx xx
100 10000 5000 5000 50.00 50.00 100 50 19000 190 9000 90 90
200 18000 5000 13000 25.00 70.00 95 80 38000 190 20000 100 100
300 27000 5000 22000 16.66 73.33 90 90 57000 190 30000 100 100
400 38000 5000 33000 12.50 82.50 95 110 76000 190 38000 95 95
500 50000 5000 45000 10.00 90.00 100 120 95000 190 45000 90 90
600 66000 5000 61000 8.33 101.66 110 160 114000 190 48000 80 80
700 84000 5000 79000 7.14 112.85 120 180 133000 190 49000 70 70
800 104000 5000 99000 6.25 123.75 130 200 152000 190 48000 60 60
900 126000 5000 121000 5.55 134.44 140 220 171000 190 45000 50 50
1000 150000 5000 145000 5.00 145.00 150 240 190000 190 40000 40 40

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 d. 300 units minimizes ATC ($90) and maximizes profit margin ($100)

e. 700 units will maximize profit ($49,000), which will also maximize the value of the firm. The
shareholder/owners will not want to fire you.
f. Tripling TFC to $15,000 will have no effect on the profit-maximizing decision: Q* is still 700
units. Unfortunately, the profit associated with 700 units will fall by $10,000 to $39,000.
g. Your spreadsheet columns 9 – 13 will now look like:

(1) … (9) (10) (11) (12) (13)

PROFMARG
AVGPROF
PROF
Q TR MR
0 0 xx -5000 xx xx
100 6500 65 -3500 -35 -35
200 13000 65 -5000 -25 -25
300 19500 65 -7500 -25 -25
400 26000 65 -12000 -30 -30
500 32500 65 -17500 -35 -35
600 39000 65 -27000 -45 -45
700 45500 65 -38500 -55 -55
800 52000 65 -52000 -65 -65
900 58500 65 -67500 -75 -75
1000 65000 65 -85000 -85 -85

100 units now maximizes profit by minimizing loss (–$3,500).

3. a.
Number of Real Marginal Revenue
Estate Agents Product

1 $40,000

2 34,000

3 30,000

4 24,000

5 16,000

6 8,000

b. Two agents should be hired. The third agent adds only $30,000 to total revenue but adds $32,000
to total cost.
c. Four agents.
d. 1, $60,000; 2, $51,000; 3, $45,000; 4, $36,000; 5, $24,000; 6, $12,000.
e. Four agents.
Chapter 11: Managerial Decisions in Competitive Markets
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manner.  This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4. A support price above the price that would prevail in the absence of controls will induce new
farmers to enter the market. These new (marginal) firms will have higher costs than the farmers
already producing because their land (and perhaps other inputs) will be less productive. Even
higher support prices would only attract even more marginal farmers.

5. In the short run, increased insurance rates could raise the income of insurance agents. If the
demand for insurance is inelastic, an increase in insurance rates will increase agents' income. In
the long run, the increase in income will attract new agents into the market (provided that entry is
unrestricted). The new agents will take some of the established customers and potential new
customers from the incumbent agents, reducing the number of policies written per agent. Agents'
income will continue to decrease until entry ceases, i.e., until income again reaches a "normal"
level.

6. Firms engage in research and development (R&D) in order to earn profits from introducing new
products or from discovering more efficient methods of production. Firms in a competitive
industry have little incentive to invest in R&D because any profit would be quickly competed
away. Anything that lengthens the period before innovations are imitated will encourage R&D.
Note, however, that if firms do develop new products, one of the assumptions of a competitive
market (a homogeneous product) will be violated.

7. a. The plant in Miami should continue to be operated because the firm loses only $60,000 per month
if the plant is operated; but would lose $68,000 if the plant is shut down. We can deduce that
total revenue exceeds variable costs by $8,000. This $8,000 can be applied toward fixed costs so
the firm loses only TFC – $8,000, which in this case is 68,000 – 8,000 = $60,000. Thus, the
President is correct in recommending that the firm continue to operate the Miami plant in the
short run.
b. While it is true that the level of fixed costs do not, in any way, influence the shut down (or
output) decision, TFC does represent the loss to the firm of shutting down operations. If the
manager makes the correct shutdown decision by comparing P to AVC, the loss from producing
will be less than TFC. The president's statement implies that P > AVC. Even if TFC were higher
than $68,000, the firm still loses $8,000 less when it produces where MR = MC than when it shuts
down.
8. a. Production costs will rise because the entry of new firms encouraged by economic profits will bid
up input prices for all the firms in the remodeling industry. Input prices would not be bid up if
the industry is a constant cost industry.
b. Price will fall because profit will encourage entry, supply will shift rightward, and equilibrium
price will fall.
c. Economic profits will fall to zero as entry occurs in the long run.
9. The pushcart owner must at least be covering his opportunity costs at this fee. The city of New
York is earning the rent in this case because it controls the location, which is the reason for the
high returns. The pushcart owner is probably not making much, if any, economic profit with the
new license fee.
10. a. There are two ways grocery and gasoline markets may fail to be competitive markets.
(1) Even though a large city has many grocery stores and gasoline stations within the
metropolitan area, consumers of groceries and gasoline typically shop close to home. So a
large city comprises many smaller geographic markets for groceries and gasoline. Within

Chapter 11: Managerial Decisions in Competitive Markets

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 these smaller local markets, there may be only a few grocery stores and gasoline retailers, a
situation that provides some ability for individual firms to influence price.
(2) Another possible divergence from competition results if the firms sell differentiated products.
The characteristics of grocery stores and gasoline stations may not be as standardized as they
seem. Grocery stores and gasoline stations can vary in terms of the quality of customer
service, the various brand names offered, and particularly location.
b. For either of the two reasons in part a, grocery and gasoline firms may possess some degree of
market power, and so face demand curves that are not perfectly elastic (i.e. horizontal). In the
long run, however, the lack of entry barriers will likely lead to entry of rivals in each geographic
market until economic profits are competed away, i.e. equal to zero in long-run competitive
equilibrium.
c. Because entry and exit in grocery and gasoline markets is typically unrestricted, we would expect
firms in these markets to earn zero economic profit in the long run. As you will see in the next
chapter, this outcome is predicted for monopolistically competitive markets in long-run
equilibrium.
11. The statement is correct in the sense that the Brazilian division should be shut down if losses
exceed TFC. If management mistakenly continues to operate the Brazilian division if and when
price falls below AVC, then more than TFC could be lost.

12. a. The long-run competitive equilibrium price for milk is the lowest possible price consumers can
pay for milk and still create financially viable dairy farms. The competitive market price just
covers all costs, including a payment to farm owners equal to their opportunity costs.
b. Every farmer knows that if each one of them produced 10 percent less milk, the market-
determined price would be higher. The problem is that reducing output is voluntary, and each
farm has an incentive to cheat on any agreement by continuing to produce the same amount (or
even more) milk while every one else cuts their production. Of course, they all cheat and price
remains the same.
13. a. AVC = 125 – 0.21Q + 0.0007Q2
b. Qm = –b/2c = –(–0.21)/(2)(0.0007) = 150.00
AVCmin = 125 – 0.21(150) + 0.0007(150)2 = $109.25
c. Since P = $115 > $109.25 = AVCmin, the firm should produce.
d. Setting P = MC, 115 = 125 – 0.42Q + 0.0021Q2 0.0021Q2 – 0.42Q + 10 = 0

Q1, Q2 = (0.42  )/(2 × 0.0021)

Q1 = 0.116/0.0042 = 27.62  28
Q2 = 0.724/0.0042 = 172.38  172
AVC172 = 125 – 0.21(172) + .0007(172)2 = $109.59; P > AVC so produce
AVC28 = 125 – 0.21(28) + 0.0007(28)2 = $119.67; P < AVC so would not produce Q = 28.
e. TR = PQ = (115)(172) = $19,780
TVC = 172 × AVC172 = 172 × 109.59 = $18,849.48
TC = TVC + TFC = $18,849 + 3,500 = $22,349
π = TR – TC = –$2,569
f. No, fixed costs do not matter. Note that when fixed costs are $4,000, the firm loses $3,069 ($500
more than when TFC = $3,500). Since neither P nor AVC changed, P is still greater than AVC
and the firm should produce 172 units where P still equals MC.

Chapter 11: Managerial Decisions in Competitive Markets

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14. a. U.S. airline markets appear to be highly competitive for several reasons. First, entry of new
airlines and exit of airlines are both common, suggesting that no barriers to entry or exit exist.
Second, consumers typically view different airlines as very close substitutes, and very small price
differences will cause travelers to switch to the lower-priced airline. Third, airline profits swing
from periods of positive profits to periods of negative profits, with five-year average profits close
to zero for most airlines. Finally, even in city-pair markets where only a few airlines compete,
price competition is keen and profits seldom approach monopoly profit levels.
b. Increasing jet fuel prices cause both the marginal and average total cost curves to shift upward,
which increases total cost and reduces profit at every level of output (passenger miles). In the
short-run, an increase in SMC for every firm causes the short-run industry supply to shift
leftward, pushing up equilibrium airfares in the short run. Because demand for air travel is not
perfectly inelastic, the full increase in marginal cost will not be passed along in higher airfares.
In the long run, higher jet fuel prices will cause the LAC curve to shift upward. Since price is
equal to minimum LAC, the full amount of increase in cost will be passed along to passengers in
the form of higher airfares.

15. a. While a firm can survive in the short-run with higher costs than its rival firms, it cannot survive in
the long run if its LAC curve lies above the LAC curves of its rivals. In the long run, price is
equal to minimum LAC of the low-cost producers, not the high-cost producer. The high-cost
producer cannot raise price above its low-cost rivals’ price in order to cover its higher costs
because it is selling a commodity (demand is horizontal) and it will lose all its sales.
b. The “sometimes” situation refers to the short run if price is less than ATC for the low-cost
producer. In this situation, even the low-cost firm will earn negative profit: it is a price-taker and
cannot raise price above ATC in the short run. However, in the long run, if one firm has lower
costs than the typical firm because it employs a super productive resource, then this situation is
not “bad”. The super productive resource will earn economic rent and the firm will break even
with zero economic profit.

Chapter 11: Managerial Decisions in Competitive Markets

2016 by McGraw-Hill Education.  This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner.  This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.