Shutdown Rule

• Shutdown rule 1: The firm shuts down only if it can reduce its loss by doing so.

• Shutdown rule 2: The firm shuts down only if its revenue is less than its avoidable cost.

– E.g., R=$2,000, VC=$1,000, F=$3,000, Profit=-$2,000?

– What if R=$500, VC=$1,000, F=$3,000, Profit=-$3,500?

Competition in the short run

• Short-run competitive profit maximization

– Where its marginal profit is zero or where its marginal cost equals its marginal revenue

– A competitive firm can sell as many units of output as it wants, the revenue is R=pq.

– Because a competitive firm’s marginal revenue equals the market price, a profit maximizing competitive firm produces the output where Mc(q)=p

How a Competitive

Firm Maximizes

Profit

Shutdown Rule

• Shutdown rule 1: The firm shuts down only if it can reduce its loss by doing so.

• Shutdown rule 2: The firm shuts down only if its revenue is less than its avoidable cost.

– R<VC,

• R=P*Q, VC=AVC*Q, Divide both sides by Q

– P<AVC

The Short-Run Shutdown Decision

How the Profit-Maximizing Quantity Varies with Price

Chapter 9

Applying the Competitive market

(Welfare Analysis)

Consumer Welfare

• Economists/policy makers want to know how much consumers benefit/harmed by shocks affect the equilibrium price and quantity.

• Comparison of utility function is not practical for the measure of consumer benefit/harm.– Unknown utility function– Un unified measure of utils

• Measure of welfare in terms of dollar!– Instead of asking “How many utils would you gains

if your daily commute decreased by 15 minutes?”– “How much would you pay to shorten your daily

commute by 15 min?”

Measuring consumer welfare using a demand curve

• Consumer welfare: the benefit a consumer gets from consuming that good minus what the consumer paid to buy the good (e.g., your willingness to pay for a soft drink ~ marginal willingness to pay ~ when you’re thirsty over what you actually pay)

• Marginal willingness to pay: the maximum amount of a consumer will spend for an extra unit.

Consumer Surplus: The area under the demand curve and above the market price up to the quantity the consumer buys.

Effect of a price change on consumer surplus

• Supply curve shifts upward, new sales tax:

• The equilibrium price rises, reducing consumer surplus.

Producer Welfare

• Producer surplus (PS): The difference between the price received by seller and the minimum amount necessary for the seller to be willing to produce the good.

• PS: The area above the supply curve and below the market price up to the quantity actually produced.

• Measuring producer surplus using a supply curve, marginal cost curve above its minimum average variable cost.

MC curve=Supply curve, above AVC

Producer Surplus

• PS = R - VC• π = R – C = R – (VC + F)• Difference between PS and π is Fixed cost.• Long run: PS = π