Managerial Economics

Perfectly competitive markets

Profit maximization
(Recap of production and cost functions)

BM - Term 1

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 What defines a market structure?

 Industry concentration
 Measure of marker power to firms
 Lerner index = (P – MC) / P
 Technology and hence cost structure of firms
 Product differentiation
 Demand conditions
 Potential for entry
 Possibility of mergers – horizontal and vertical
integration

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 Metric of industry concentration

Herfindahl–Hirschman Index = ∑ si2

where, si is the market share of firm i
 In perfectly competitive markets, there are very large
number of firms, and hence si → 0 for all firms. Therefore,
HHI → 0
 In a market where there is one dominant firm having 50%
of sales, and a very large number of firms having the rest of
the market, for the dominant firm s1 = 0.5 and for the other
firms si → 0. HHI will be approximately close to 0.25.
 In a duopoly where each firm gets 50% of total sales, HHI =
0.5
 In a market monopolized by 1 firm, HHI = 1

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 Perfect Competition
 Very large number of buyers and sellers
 HHI = 0
 Market power of each firm is zero
Lerner Index = [(P – MC)/P] = 0
 Firms are equal in size
 Sellers selling homogenous products
 Firms use same technology and hence their cost
structure is same
 Price is determined by the market forces and the
agents act as price takers
 Free entry and exit
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 Understanding cost functions from production function -
Recap

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 Some definitions

• Marginal Product (Return to factor):

Change in output for a very small change in the variable
input (labor)
MPL = δQ / δL

• Average Product:
Output per unit of the variable input (labor)
APL = Q / L

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 Total
output Total
x product
TP

Labor
units L
Marginal A
product MP

B Labor
units L
L1 L2
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 Typical Manufacturing Production Fn.
 In zone I, it is increasing and convex i.e., it exhibits increasing
returns to factors
δx/ δL = MPL > 0
δ2x/ δL2 = (δ MPL / δL) > 0

 In zone II, it is increasing and concave, i.e., it exhibits

diminishing returns to factors
δx/ δL = MPL > 0
δ2x/ δL2 = (δ MPL / δL) < 0

 In zone III, it is decreasing i.e., it exhibits negative returns to

factors
δx/ δL = MPL < 0
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 We get variable cost by iInverting the
production function

Labor
Total
output
units L
x

Zone of Labor
Total L
units
productio output
n x

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 Cost Function

c(x)+F TC

TVC = wL

TFC

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 Marginal and average costs - definitions
• Marginal Cost:
Change in cost (variable) for a very small change in the output
(quantity)
MC = dc(x) / dx
• Average variable Cost:
Variable cost per unit of output
AVC = VC / x
• Average fixed cost:
Fixed cost per unit of output
AFC = FC / x
• Average Cost:
Cost per unit of output
AC = TC / x = (FC + VC) / x = AFC + AVC

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 AVC and MC on Variable Cost Function

c(x)

TVC

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 Short run AC and MC

AC, MC AC
MC
AVC

AFC
Q

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 MC cuts AVC at the minima
TC = FC + VC = F + c(x)
AC = TC / Q = [F + c(x)] / x = [F / x] + [c(x) / x]
AVC = c(x) / x
• First order condition for minima:

d(AVC)/ dx = 0
or, [(dc(x)/ dx).x – c(x)] / x2 = 0
or, (dc(x)/ dx) = c(x) / x
or, MC = AVC
• Second order condition

d2(AVC)/ dx2 > 0

dMC/dx > 0
• 2nd order condition implies
• The slope of the MC curve is more than the slope of the AVC curve
(which is 0 at the minimum point) at the point of intersection, i.e., MC
is upward sloping at AVCmin
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 MC cuts AC at the minima
AC = TC / Q = [F + c(Q)] / Q = [F / Q] + [c(Q) / Q]

• First order condition for minima:

δ(AC)/ δQ = 0
or, [- F + (δc(Q)/ δQ).Q – c(Q)] / Q2 = 0
or, (δc(Q)/ δQ) = [F + c(Q)] / Q
or, MC = AC

• Second order condition implies that the MC curve is upward

sloping at the minimum point of the AC.

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 Definitions: Revenue, contribution and profit

Revenue[R] = Quantity Sold [x] . Price [P]

Cost [C] = Var.Cost [c(x)] + Fixed Cost [F]

Contribution [] = Revenue [R] – Var.Cost [c(x)]

= P.x – c(x)

Profit [] = Contribution [] – Fixed Cost [F]

= P.x – c(x) – F

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 Revenue and cost function

Rs. C = c(x) + F
R = P.x

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 Rs. C = c(x) + F
R = P.x

x
 in Rs.
Break-even
Profit
point
maximized

x* x
Profit
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function
 Profit maximizing condition for a price taker
firm

Profit function:
 = P.x – c(x) – F
First order condition:
P = (MR) = dc(x)/dx = MC
Second order condition:
d2c(x)/dx2 > 0

Profit is maximized when the MC is equal to the

market price and the MC is increasing.

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Reading
• Besanko & Braeutigam. Ch. 8 (Sec. 8.2)
Ch. 9 (Sec 9.1, 9.2)

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