Shutdown versus Investment
The Shutdown Decision
  • Fixed costs must be paid even if all output ceases.
  • A firm should shut down only if total revenues are less than total variable costs.
  • Price versus AVC
    • Where price exceeds average variable cost but not average total cost, the profit maximum actually minimizes losses.
  • The Firm’s Shutdown Point
    • That rate of output where price equals minimum AVC.
    • When price does not cover average variable costs at any rate of output, production should cease.
The Investment Decision
  • The decision to build, buy, or lease plant and equipment; to enter or exit an industry.
  • Investment decisions are long-run decisions (i.e., a period of time long enough for all inputs to be variable)
  • Long-Run Costs
    • A producer will want to build, buy or lease a plant that is most efficient for the anticipated rate of output.
Determinants of Supply
  • Short-run determinants
    1. The price of factor inputs
    2. Technology  (the available production function)
    3. Expectations (for costs, sales, technology)
    4. Taxes
  • The marginal cost curve is the short-run supply curve for a competitive firm.
  • Supply Curve – a curve describing the quantities of a good a producer is willing and able to sell (produce) at alternative prices in a  given time period, ceteris paribus.
  • Supply Shifts - If any determinant of supply changes, the supply curve shifts.
Taxing Business
  1. Property taxes.
    • property taxes are a fixed cost
    • they don't affect the MC curve
    • they raise ATC thus reducing profits
    • lower profits may alter investment decisions (a long-run decision)
  2. Payroll taxes.
    • payroll taxes increase marginal costs and thus, reduce the optimal level of output
    • they shift the MC curve
    • therefore ATC must shift as well
    • they lower total and per-unit profits
  3. Profit taxes
    • profit taxes are neither a fixed or variable cost
    • they do not affect marginal costs or prices
    • do not affect production level decisions but may affect investment decisions
  4. Tax Policy.
    • KEY POINT -- tax policy affects production and investment decisions
Competitive Markets:
The Market Supply Curve
  • Equilibrium price – The price at which the quantity of a good demanded in a given time period equals the quantity supplied.
  • Market supply – The total quantities of a good that sellers are willing and able to sell at alternative prices in a given time period, ceteris paribus.
  • The market supply curve is the sum of the marginal cost curves of all the firms
  • the market supply of a competitive industry is determined by:
    1. The price of factor inputs
    2. Technology
    3. Expectations
    4. Taxes
    5. The number of firms in the industry
Entry and Exit
  • Investment Decision  - The decision to build, buy, or lease plant and equipment; to enter or exit an industry.
  • The investment decisions shift the market supply curve to the right.
  • The profit motive drives these investment decisions.
Tendency Toward Zero Profits
  • Economic profits – The difference between total revenues and total economic costs.
  • An increase in market supply causes the economic profits to disappear.
  • When economic profits disappear, entry ceases and the market price stabilizes.
  • Competitive market - A market in which no buyer or seller has market power.
  • As long as it is easy for existing producers to expand production or for new firms to enter an industry, economic profits will not last long.
Low Barriers to Entry
  • Barriers to entry – obstacles that make it difficult or impossible for would-be producers to enter a particular market, such as patents.
  • Barriers to entry may include:
    • Control of essential factors of production.
    • Control of distribution outlets.
    • Well-established brand loyalty.
    • Government regulation.
Market Characteristics of Perfect Competition
  • Some of the structures, behaviors and outcomes of a competitive market are:
    • Many firms
    • Perfect information
    • Identical products
    • MC = PRICE = MR   (all competitive firms will seek to expand output until marginal cost is equal to the market price of the product being produced)
    • Low barriers to entry
    • Zero economic profit
Relentless Profit Squeeze
  • The sequence of events common to a competitive market situation includes:
    1. High prices and profits signal consumers’ demand for more output.
    2. Economic profit attracts new suppliers.
    3. The market supply shifts to the right.
    4. Prices slide down the market demand curve.
    5. A new equilibrium is reached with increased quantities being produced and sold and the economic profit approaching zero.
    6. Throughout the process, producers experience great pressure to keep ahead of the profit squeeze by reducing costs, a pressure that frequently results in product and technological innovation.

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this page is maintained by Reed Fisher
last updated January 15, 2011