Ajax Company

Scenarios for a Firm in

Perfect Competition

Table of Contents

Cost Curves Profit-Maximization Find Total Revenue o

n a Graph Find Total Cost on a

Graph Economic Profit Find Total Variable C

ost on a Graph

Find Total Fixed Cost Normal ProfitEconomic Loss

Stay in BusinessShut Down PointShut Down

Ajax Company Cost Schedule

Output AVC ATC MC1 100 400 1002 75 225 503 70 170 604 73 148 805 80 140 1106 90 140 1407 103 146 1808 119 156 2309 138 171 29010 160 190 360

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$

AVC

ATC

MC

MC

ATC

AVC

Suppose the market equilibrium price is $180.

Since the firm in perfect competition is a price taker, it can charge no more than the market equilibrium price.

P = MR = AR and the firm’s demand curve will be perfectly elastic at the market equilibrium price.

Ajax Company Data

Output AVC ATC MC P = AR MR1 100 400 100 180 1802 75 225 50 180 1803 70 170 60 180 1804 73 148 80 180 1805 80 140 110 180 1806 90 140 140 180 1807 103 146 180 180 1808 119 156 230 180 1809 138 171 290 180 18010 160 190 360 180 180

The firm’s demand curve will be perfectly elastic at the market equilibrium price of $180 and MR and AR will both be $180.

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AVC

ATC

MC

D = MR = AR

MC

ATC

AVC

Find the Profit Maximizing Quantity by Finding where MR=MC.

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AVC

ATC

MC

D = MR = AR

MC

ATC

AVC

MC=MR

Drop a Perpendicular LineDown to the Quantity Axis to Determine the Profit-Maximizing Quantity.

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AVC

ATC

MC

D = MR = AR

MR=MC

MC

ATC

AVC

To Find Total RevenueCompute P x Q

Ajax Company Data

Output AVC ATC MC P = AR MR TR=PxQ1 100 400 100 180 180 1802 75 225 50 180 180 3603 70 170 60 180 180 5404 73 148 80 180 180 7205 80 140 110 180 180 9006 90 140 140 180 180 10807 103 146 180 180 180 12608 119 156 230 180 180 14409 138 171 290 180 180 162010 160 190 360 180 180 1800

To find Total Revenue for the Profit-Maximizing Quantity on the Graph, start at the quantity where MR=MC.

The Profit Maximizing Quantity is 7 units of output.

The Price needed to sell 7 units of output can be found by going from 7 units of output on the output axis up to the Demand Curve.

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AVC

ATC

MC

D = MR = ARC

D

MC

ATC

AVC

The distance from the originto 7 units of output is Q.

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AVC

ATC

MC

D = MR = AR

A D

MC

ATC

AVC

Since the distance from 7 up to the Demand Curve is the Price and the distance from the origin to 7 units of output is Q, Total Revenue is P x Q or the height of a rectangle times its base or the area indicated by ABCD.

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AVC

ATC

MC

D = MR = AR

MC

ATC

AVC

A

B C

D

TR = ABCD

To Find Total Cost Compute TC = ATC x Q.

Ajax Company Data

Output AVC ATC MC P = AR MR TR=PxQ TC=ATCxQ1 100 400 100 180 180 180 4002 75 225 50 180 180 360 4503 70 170 60 180 180 540 5104 73 148 80 180 180 720 5925 80 140 110 180 180 900 7006 90 140 140 180 180 1080 8407 103 146 180 180 180 1260 10228 119 156 230 180 180 1440 12489 138 171 290 180 180 1620 153910 160 190 360 180 180 1800 1900

Find the ATC for 7 Units of Output by going from 7 units of output on the quantity axis up to the ATC curve.

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AVC

ATC

MC

D = MR = AR

MC

ATC

AVC

Draw the Total Cost Rectangle by drawing a base of 7 units (this is Q) times the height which is the ATC for 7 units. It is the area AEFD.

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AVC

ATC

MC

D = MR = AR

A

E F

D

MC

ATC

AVC

TC = AEFC

If Total Cost and Total Revenue are drawn on the same graph

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AVC

ATC

MC

D = MR = AR

A

B C

D

E F

MC

ATC

AVC

TR = ABCETC = AEFD

TR - TC = Economic ProfitThis is the rectangle EBCF.

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AVC

ATC

MC

D = MR = AR

A

B C

D

E FP R O F I T

MC

ATC

AVC

Economic Profit = EBCF

Now let’s see the whole process again.

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AVC

ATC

MC

D = MR = AR

A

B C

D

E FP R O F I T

MC

ATC

AVC

TVC = AVC x QFirst find AVC for the Profit-Maximizing Quantity

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AVC

ATC

MC

D = MR = AR

AVC

MC

ATC

Then draw the AVC x Q = TVCrectangle.

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AVC

ATC

MC

D = MR = AR

A

G H

D

TVC = AGHD

MC

ATC

AVC

AFC for the Profit-Maximizing Quantity is the vertical distance between ATC and AVC at 7 units of output.

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AVC

ATC

MC

D = MR = AR

ATC

AVC

F

H

TFC is the rectangle which has a height of AFC and a base of Q.

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AVC

ATC

MC

D = MR = AR

E

G

F

H

TFC = GEFH

MC

ATC

AVC

Notice that the Total Variable Cost rectangle plus the Total Fixed Cost rectangleequal the Total Cost rectangle.

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AVC

ATC

MC

D = MR = AR

A

G H

D

E FTotal Fixed Cost

Total Variable Cost

Total Cost = AEFD MC

ATC

AVC

Now suppose the market demand decreases and the market equilibrium price falls to $140.

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AVC

ATC

MC

D=AR=MR

MC

ATC

AVC

Find the Profit Maximizing Quantity by finding where MR=MC

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AVC

ATC

MC

D=AR=MR

MR=MC

MC

ATC

AVC

Drop a perpendicular line down to the quantity axis to find the Profit-Maximizing quantity.

The Profit-Maximizing quantity is now 6 units of output.

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AVC

ATC

MC

D=AR=MR

MC

ATC

AVC

The Total Revenue rectangle is AR x Q or P x Q

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AVC

ATC

MC

D=AR=MR

A

B C

D

TR = ABCD

MC

ATC

AVC

The Total Cost rectangle is ATC x Q

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AVC

ATC

MC

D=AR=MR

A

E F

D

ATC

TC = ATC x Q =AEFD

AVC

MC

FD = AT C for 6 units

If you compare the Total Revenue and Total Cost rectangles, you will notice they are the same.The firm is breaking even orearning a normal profit.Let’s see them again.

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AVC

ATC

MC

D=MR=AR

A

B C

D

MC

ATC

AVC

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AVC

ATC

MC

D=MR=AR

A

E F

D

MC

ATC

AVC

What happens if the market equilibrium price falls to $110?

The demand curve, marginal revenue curve, and average revenue curve are now horizontal at $110.

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AVC

ATC

MC

D = MR = AR

ATC

AVC

MC

Can the firm still break even?No. AR < ATC at every level of output.

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AVC

ATC

MC

D = MR = AR

ATC

AVC

MC

Find the Profit-Maximizing Quantity by Finding where MR=MC and dropping down to the quantity axis.The Profit-Maximizing Quantity is now 5.

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AVC

ATC

MC

D = MR = AR

MR=MC

MC

ATC

AVC

The Total Revenue rectangle is AR x Q or P x Q

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AVC

ATC

MC

D = MR = AR

A

B C

D

MC

ATC

AVC

The Total Cost rectangle is ATC x Q

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AVC

ATC

MC

D = MR = AR

A

E F

D

ATC

MC

AVC

Draw Total Cost and Total Revenue on the Same Graph

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AVC

ATC

MC

D = MR = AR

A

B C

D

E F

MC

ATC

AVC

In this case the Total Cost rectangle (AEFD) is larger than the Total Revenue rectangle (ABCD), so the firm is making aneconomic loss (BEFC)

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AVC

ATC

MC

D = MR = AR

A

B C

D

E FEconomic loss

MC

ATC

AVC

If the firm is making an economic loss, should it shut down?It depends.The firm wants to minimize its losses.

The firm needs to determine if it minimizes its losses by continuing to produce or by shutting down.

If the firm decides to shut down, its loss will be its Total Fixed Cost (because the Total Revenue is zeroand the Total Cost IS its Total Fixed Cost when output is zero).

What is the TFC on the graph for 5 units of output?It is TC - TVC.

TC for 5 units of output was the rectangle AEFD:

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AVC

ATC

MC

D = MR = AR

A

E F

D

MC

ATC

AVC

TVC = AVC x Q for 5 units of output is the rectangle AGHD

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AVC

ATC

MC

D = MR = AR

A

G H

D

AVC

MC

ATC

TFC = TC - TVC orAEFD - AGHD

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AVC

ATC

MC

D = MR = AR

E F

G H Total Fixed Cost

A D

Total Fixed Cost = AEFC - AGHD = GEFHMC

ATC

AVC

We already found the total economic loss when the market price was $110 and the firm was loss minimizing.This was the rectangle BEFC.

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AVC

ATC

MC

D = MR = AR

A

B C

D

E FEconomic loss

Economic Profit = TR - TC = ABCD - AEFD = -BEFC = an Economic loss

MC

ATC

AVC

The next step is to compare the loss when the firm shuts down (TFC) to the economic loss when it produces at the output level where MR = MC.

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AVC

ATC

MC

D = MR = AR

E F

G H

A D

B C

Total Economic Loss = BEFCTotal Fixed Cost = GEFH Which is the larger loss?

Economic lossTotal Fixed Cost

MC

ATC

AVC

In this case, the firm has a larger economic loss if it shuts down and owes its Total Fixed Cost.

What would happen if the equilibrium market price fell down to $70?

D, MR, and AR would now be horizontal at $70

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

At this lower price, AR<ATC by a larger amount than before.The firm is making a larger economic loss.Should it shut down?

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

Again we must compare what the firm loses if it stays in business to the total fixed cost it loses if it shuts down.Which will minimize the firm’s loss?

If it stays in business, it will produce where MR = MCat 3.5 units of output

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

Notice that the red dotted line which represents AR is the same vertical distance as the height to the AVC curve. This means that at $70, AR = AVC

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

TR = AR x Q for 3.5 units of output.Since AR = AVC at $70, TR also equals TVC.TR = AR x Q = AVC x Q = TVC

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

A

BC

D

TR = ABCD = TVC

TC = ATC x Q for 3.5 units

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

A

E F

D

Put both Total Revenue and Total Cost on the same graph and find the Total Economic Loss BEFC

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

Economic

Loss

A

B

E F

C

D

Total Economic Loss = TC - TR.Since TR = TVC when the price is $70, Economic Loss = TC - TVC = TFCThis means that when the price is $70, the firm’s economic loss is its Total Fixed Cost.

If it shuts down it owes its TFC.So this firm owes its TFC if it operates where MR = MC at 3.5 units of output OR it owes its TFC if it shuts down.The loss is the same in either case.

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AVC

ATC

MC

MC

ATC

AVC

D=MR=AR

Economic Loss

A

B

E F

C

D

TFC

So what should this firm do when the price is $70, stay in businessor shut down?It doesn’t matter.The firm will most likely stay in business hoping things will improve.

Now what happens if the market equilibrium price falls below $70, perhaps to $60?

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AVC

ATC

MC

MC

ATC

AVC

D = MR = AR

Notice now that AR < AVC.

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AVC

ATC

MC

MC

ATC

AVC

D = MR = AR

This means that TR < TVC.The firm is not earning enough revenue to even cover its Total Variable Cost.

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AVC

ATC

MC

MC

ATC

AVC

D = MR = AR

A

B C

D

G H

TR = ABCETVC = AGHD

The firm owes all of its fixed costsplus part of its variable costs.It minimizes its loss by shutting down where it will only owe its Total Fixed Cost.

Its economic loss if it stays in business is TR - TC or BEFC

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AVC

ATC

MC

MC

ATC

AVC

D = MR = ARB

A

C

D

E F

Total Economic Loss = BEFC

Economic loss

Its total economic loss if it shuts down is its Total Fixed Costor GEFH

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AVC

ATC

MC

MC

ATC

AVC

D = MR = AR

E

A

F

D

G H

TC = AEFDTVC = AGHDTFC = GEFH

TFC

Let’s see both together.

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AVC

ATC

MC

MC

ATC

AVC

D = MR = ARB

A

C

D

E F

Total Economic Loss = BEFCTFC = GEFH

G H

Total EconomicLoss

TFC

Total Economic Loss is minimized if the firm shuts down.