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SS-15-16

The document discusses microeconomic analysis focusing on perfect competition, detailing how firms determine revenue, profit maximization, and production decisions. It explains the relationship between marginal revenue and marginal cost, and outlines conditions under which firms should shut down production in the short run. Additionally, it covers long-run supply dynamics and the conditions for firms to remain in the market based on average costs and total revenues.

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4 views

SS-15-16

The document discusses microeconomic analysis focusing on perfect competition, detailing how firms determine revenue, profit maximization, and production decisions. It explains the relationship between marginal revenue and marginal cost, and outlines conditions under which firms should shut down production in the short run. Additionally, it covers long-run supply dynamics and the conditions for firms to remain in the market based on average costs and total revenues.

Uploaded by

dalqunaishotmail.com
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Microeconomic Analysis

ECON 520 - SS 15-16


KFUPM - Fall-22
Dr. Muhammad Imran Chaudhry, CFA
Modelling Revenues-Perfect Competition
• In perfectly competitive markets, firms are price-takers, and
need to only decide how much to produce.
– Revenue of a firm is the amount of money it brings in from the sale
of output and is determined by price of goods sold times number of
units sold: Total revenue = Price × Quantity sold.
– For competitive firms, the price it receives does not depend on the
quantity it chooses to sell. Price comes from the intersection of the
market supply-curve and the market-demand curve.
• In perfectly competitive markets, marginal revenue of a firm
is equal to the market price i.e., each unit of output can be
sold at market price.
– Marginal revenue curve represents a given firm’s demand curve.
• Firm profits are the difference between total revenues and
total costs: Profits = Total revenues − Total costs.
– We need to find production level at which profits are maximized?
Firm Supply Decisions-Perfect Competition
• To determine production levels that maximize firm profits, we
need to think about marginal revenues and marginal costs.
– If firms can produce another unit of output at a marginal cost that is
less than the market price, it shall do so, because the firm would be
making a profit on producing that unit.
– Decision rule: Firms expand production until the point where marginal
revenue is equal to marginal cost.
• Firms produce at the point where price equals marginal cost (marginal
revenue equals price in a perfectly competitive market).
– MR=MC rule allows us to link the market price to firm’s marginal cost
curve, and determine how a competitive firm changes its output (in
the short-run) in response to a change in market prices.
• This is the definition of supply curve, i.e., relationship between quantity
supplied and market prices.
• Instead of choosing the optimal production, the firm might want to shut
down and produce zero. When?
Optimal Production-Maximizing Profit

 = TR – TC $
MC

 = Pq - [FC + VC]
MR
$P1

quantity
What output should the firm produce? q1
➔ produce until MR = MC (Principle of
Optimality)
• If MR > MC ➔ produce more
Firms maximize profit
• If MR < MC ➔ produce less What is TR = ?
What is TC = ?
Firm’s (short-run) shut-down decisions
• Shutdown: The short-run decision to not produce anything i.e.,
zero output in a time period. When should a firm shutdown:
– Fixed costs need to be paid regardless of production levels. Therefore,
from the principle of thinking on the margin we know that fixed costs
should not affect short-run production decisions.
• Firms shutdown if pay-offs from zero production is greater than
pay-offs from non-zero production:
– Pay-offs from zero output: - Fixed Cost.
– Pay-offs from non-zero output: Revenue – Variable Cost – Fixed Cost.
• Shutdown condition translates into:
– -Fixed Cost > Revenue – Variable Cost – Fixed Cost.
– Fixed costs are sunk in the short run, hence fixed costs do not affect
shut down decision.
– Simplifying, we get Variable Costs > Revenue.
– This is equivalent to saying that firms will shutdown if average variable
cost > market price (AVC > P) i.e., losing money on each output unit!
Shutdown-Graphical Analysis

$
MC
ATC Portion of the MC curve
above the shutdown
AVC point represents firm’s
short-run supply curve
PSD = Min AVC

q SD quantity

Shut down if TR < VC


Pq < (AVC)(q)
P < AVC
Long-Run Firm Supply
• Long-run supply: how much firms would produce, if allowed to
adjust fixed factors of production.
– Long-run supply curve is more responsive to price changes compared
to the short-run supply curve.
• Construction of long-run supply curve is analogous to how we
derived short-run supply curve from the marginal cost curve.
– In the long-run, no fixed factors of production, hence firms can get zero
profits by going out of business.
– Shutdown condition: In the long run, profit-maximizing firms leave the
industry if TR < TC at any output level, dividing both sides by Q, we get
shutdown AC>p i.e., the long-run price has to be at least as large as AC.
– Therefore, in the long-run, supply curve is given by the upward sloping
part of the marginal cost curve above the average cost curve.
– Total profit in the long run is computed identically to short-run profit
i.e., difference between price and average total cost multiplied by
quantity sold: (P − ATC) × Q.

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