Decker Scientific is considering an investment of$850,000 in a new product line. The company willmake the investment only if it will result in a rateof return of 20% per year or higher. If the revenueis expected to be between $290,000 and $325,000per year for each of 5 years, determine if the decisionto invest is sensitive to the projected range ofincome using an annual worth analysis.
Economics 2005 Chapter 8 Motivation: The Benevolent Dictator - Suppose I am a benevolent dictator and I am trying to figure out how much of a good to make and how much to charge for it. o My goal is to do what’s best for society (maximize total surplus) Important for this analysis: NOTE: In any market, we must always be on our demand curve or else a shortage or surplus will exist. What’ best for society - At P3, Q3, price = marginal cost - Just enough resources are used to produce this good What a firm WILL do: - A firm SHOULD set Q such that MC=P, but firms don’t maximize social welfare, they maximize profits (Firms must compete with other firms). Assume that the market is “perfectly competitive.” Perfect Competition (PC) - Perfect competition: An industry structure with many fully informed buyers and sellers of a standardized product and no obstacles to entry or exit of firms in the long run. - Standardized products (commodities): Undifferentiated products; products that are identical to one another. Five characteristics of perfectly competitive markets: 1. There are many small firms and many consumers. 2. The firms sell a homogeneous product (commodity). 3. Everyone has access to full information (buyers and sellers). 4. There is no unrestricted entry and exit to the market (but not necessarily costless). 5. Prices are not regulated by the state. Broken Down: 1. Many small firms- “price takers” a. Firms can change their level of output without affecting the price. This is referred to as “price taking.” b. There are also many small consumers who cannot affect the price either. 2. Homogeneous products (commodities) a. This requires that all firms sell goods that are interchangeable. This means consumers will only care about the price of the goods are since there is no quality difference. b. i.e. wheat, copper, stocks, anything not name-brand *These first two characteristics together mean that a single firm’s demand curve is very elastic. We will actually assume that is it perfectly elastic. The firm, therefore, will have no control over the price they charge. 3. Full information a. All buyers and sellers can “see” the demand and cost curves and know what price they should buy or sell the good for. b. If this is not the case, then sellers can scam buyers who may not know the market price of the good or what the good is. 4. Free (unrestricted) entry and exit (but not costless) a. This ensures that unprofitable firma can leave the market and that new firms can enter profitable markets. b. This entry may cost $$ but there are no barriers keeping firms from entering (legal, etc.) 5. No Price regulation a. Self-explanatory “Price Takers” - It has no price policy. - Graphing: Where does the price that is “taken” by a PC Firm come from It comes from the market equilibrium. The intersection of market supply and demand determines an equilibrium price in the market, which is then “taken” as the price by each of the PC Firms. Perfect Competition - The firm’s only choice in perfect competition is to choose a level of output that will maximize profits. - In the short run, to maximize profits, the firm would choose the level of output such that MR=MC. *In Perfect Competition, the demand curve (price curve) is always flat. Economics 2005 Chapter 8 Cont’d Review: In the short run, a firm can: 1. Earn positive economic profits 2. Earn zero economic profits 3. Suffer economic losses but continuing to operate to reduce or minimize those losses 4. Shut down *Profit = Q(P-ATC) - By now we have looked at 1 and 2. For 3 and 4, we need to think about what happens when a firm is earning negative profit. In this case, the firm will want to minimize its loss. Minimizing Losses Operating profit or net operating revenue: Total revenue minus total variable cost (TR – TVC). In general, if revenues exceed variable costs, operating profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating. If revenues are smaller than variable costs, the firm has a negative operating profit that push total losses above fixed costs. In this case, the firm can minimize its losses by shutting down. *However, a firm could earning a negative operating profit, but different factors will lay into how that firm handles to loss (a firm may choose to not shut down). The shut-down point When the price is less than the AVC curve for all positive quantities, the firm should stop producing and bear losses equal to fixed costs. When the price is less than just the ATC curve for all positive quantities, this is the zero profit point for the firm. The short-run industry supply curve Short-run industry supply curve: The sum of the marginal cost curves (above AVC) of all firms in an industry). Short run to Long run In the short run, perfectly competitive firms can earn positive profits or negative profits. In the long run this is not possible. In the long run, all PC firms MUST earn zero profit. (Price will be pushed down to minimum ATC). If firms in an industry earn positive economic profits (P>AC), then in the long run firms will enter this industry. Such entry will shift the supply curve out thus forcing prices to fall. Firms will keep entering until profits equal 0. If profits are positive, in the long run, existing firms will continue to expand as long as their economies of scale to be realized (as long as costs are falling). Economics 2005 Chapter 8 Cont’d Review For a perfectly competitive firm in the short run, the profit-maximizing level of production is where P=MR=MC. In long run, P*=SRMC=SRAC=LRAC and profits are 0 (long run competitive equilibrium condition). If firms earn negative profits in short run, then in the long run firms will exit (drop out of) this industry. (Vice Versa) Firms will keep exiting until the remaining firms get to profits=0. *Supply curve shifts back, thus prices rise. Long Run Industry Supply Curve When long run average costs decrease as a result of industry growth, we say that the industry is a “decreasing cost” industry. When average costs increase as a result of industry growth, we say that the industry is an “increasing cost” industry. Long run industry supply curve: A graph that traces out the price and total output over time as an industry expands. In an increasing cost industry, price rises as Q rises. In a decreasing cost industry, price falls as Q increases. Perfect Competition and Efficiency Why is this the ideal market structure o A PC market achieves both “allocative” and “productive” efficiency – the market supplies the right stuff at the right pace. Allocative Efficiency The condition that ensures that the right things are produced is P=MC. If P>MC, society gains by producing more “x.” If P