8. profit maximization and competitive supply · 8. profit maximization and competitive supply...


Chapter Outline

• Perfectly Competitive Markets

• Profit Maximization

• Marginal Revenue, Marginal Cost, and Profit Maximization

• Choosing Output in the Short Run


Chapter Topics

• The Competitive Firm’s Short-Run Supply Curve

• The Short-Run Market Supply Curve

• The Long-Run Supply Curve

• The Industry’s Long-Run Supply Curve


Perfectly Competitive Markets

• Characteristics of Perfectly Competitive Markets

1) Price Taking

2) Product Homogeneity

3) Free Entry and Exit



• Price Taking

– Because each individual firm sells a sufficiently small

proportion of total market output, its decisions have no

impact on market price.

– A single firm has no influence over market price and thus

takes the price as given.



• Product Homogeneity

– When the products of all of the firms in a market are

perfectly substitutable with one another—i.e., when they

are homogeneous—no firm can raise the price of its

product above the price of other firms without losing most

or all of its business, e.g., agricultural products, copper,

iron, wood, etc.

– In contrast, when products are heterogeneous, each firm

has the opportunity to raise its price above that of its

competitors without losing all of its sales.

– The assumption of product homogeneity is important

because it ensures that there is a single market price,

consistent with supply-demand analysis.



• Free Entry and Exit

– Condition under which there are no special costs that

make it difficult for a firm to enter (or exit) an industry.

– With free entry (exit), buyers can easily switch from one

supplier to another, and suppliers can easily enter or exit

a market.


Profit Maximization

• Do Firms Maximize Profit?

– Possible objectives

Maximize revenue

Maximize dividends

Short-run profit maximization

– Impact of other objectives other than maximizing profit

For smaller firms managed by their owners, profit is likely

to dominate almost all decisions. In larger firms, however,

managers who make day-to-day decisions usually have

little contact with the owners.

Firms that do not come close to maximizing profit are not

likely to survive. The firms that do survive make long-run

profit maximization one of their highest priorities.


Marginal Revenue, Marginal Cost, and Profit Maximization

• Determining the profit maximizing output decision for

any firm:

Suppose that the firms output is q.

– Revenue (R) = P * q.

– Cost (C) = C * q.

– Hence, Profit ( ) = (total) revenue – (total) cost :

( ) ( ) ( )q R q C q


Profit Maximization in the Short-Run

0

Cost,

revenue,

profit

(€ per year)

Output (units per year)

R(q) Total revenue

Slope of R(q) = MR


Profit Maximization in the Short-Run

0 Output (units per year)

C(q)

Total cost

Slope of C(q) = MC

Why is the cost curve positive when output is zero?

Cost,

revenue,

profit

(€ per year)



Marginal revenue: change in revenue resulting from a one-

unit increase in output.

Marginal costs: increase in cost resulting from the

production of one extra unit of output.



• Comparing R(q) and C(q)

– Production level: 0-q0

C(q)> R(q)

– Negative

revenue

FC + VC > R(q)

MR > MC

– Indicates higher

revenue with

higher output. 0

Cost,

revenue,

profit

(€ per year)


R(q)

C(q)

A

B

q0 q*

)(q




– Production levels: q0 - q*

R(q)> C(q)

MR > MC

– Indicates higher revenue with higher output

– Revenue increases

R(q)

0


C(q)

A

B

q0 q*

)(q

Cost,

revenue,

profit

(€ per year)




– Production level: q*

R(q)= C(q)

MR = MC

Revenue is

maximized

R(q)

0


C(q)

A

B

q0 q*

)(q

Cost,

revenue,

profit

(€ per year)



• Question

– Why does the profit

decrease when

more(less) than q* is

produced? R(q)

0


C(q)

A

B

q0 q*

)(q

Cost,

revenue,

profit

(€ per year)




– Production level above q*:

R(q)> C(q)

MC > MR

Profit

decreases.

R(q)

0


C(q)

A

B

q0 q*

)(q

Cost,

revenue,

profit

(€ per year)



• Consequently, we can say

– Profit is maximized

when

MC = MR. R(q)

0


C(q)

A

B

q0 q*

)(q

Cost,

revenue,

profit

(€ per year)



R - C

dC or MC=

dq

CMC

q

dR or MR=

dq

RMR

q



0, so thatMR MC

MR(q) MC(q)

Thus we conclude that profit is maximized when

𝑑𝜋

𝑑𝑞=

𝑑𝑅

𝑑𝑞−

𝑑𝐶

𝑑𝑞= 0 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦



• The Competitive Firm

– Price taker.

– Denote the market output and firm output by (Q) & (q) respectively.

– Denote the market demand and firm demand by (D) & (d) respectively.

– The demand curve d facing an individual competitive market is given by a horizontal line because p is constant.


Demand and Marginal Revenue for a Competitive Firm

Output

Price

€

Output

d 4

100 200 100

Firm Industry

D

4

q Q

Price

€



• The competitive firm

– The demand of competitive firms

Regardless of the production level, the individual producer

sells all units at a price of €4.

If the producer tries to increase the price, sales decrease

to zero.

If the producer tries to lower the price, he can not increase

his sales.

P = MC = MR = AR



• The competitive firm

– Profit maximization

MC(q) = MR = P

Therefore a perfectly competitive firm should choose

its output so that marginal cost equals price:

»Price = Marginal costs


Short-Run Profit Maximization by a Competitive Firm

q0

Lost profit for

q1 < q* Lost profit for

q2 > q*

q1 q2

10

20

30

40

Price

(€per unit)

0 1 2 3 4 5 6 7 8 9 10 11

50

60 MC

AVC

ATC AR=MR=P

Output q*

At q*: MR = MC

and P > ATC

* (P - ATC) * q

or ABCD

D A

B C

q1 : MR > MC and

q2: MC> MR and

q0: MC = MR but

MC is decreasing


A Competitive Company that Generates Losses

Would this producer

continue to produce

despite a loss?

Output

AVC

ATC MC

q*

P = MR

B

F

C

A

E

D At q*: MR = MC

and P < ATC

Losses =

(P- ATC) * q* or

ABCD

Price

(€per unit)


Choosing Output in the Short-Run

• Summing up the production decision

– Profit is maximized when MC = MR.

– If P > ATC, the firm makes profits.

– If AVC < P < ATC, the firm should continue to produce

despite a loss.

– If P < AVC < ATC, the firm should shut down.


The Competitive Firm‘s Short-Run Supply Curve

Output

MC

AVC

AC

P = AVC What happens if

P < AVC?

P2

q2

P1

q1

In the short run, the firm chooses its output so that marginal cost

MC is equal to price as long as the firm covers its average

variable cost.

Price

(€per unit)



• Remark:

– P = MR

– MC = MR

– P = MC

• The supply curve of the company indicates the quantity of

goods produced at any price. Therefore,

– if P = P1, then q = q1.

– If P = P2, then q = q2.



MC

Output

AVC

ATC

P = AVC

P1

P2

q1 q2

P = MC above AVC

Shut down

Price

(€ per unit)


The Firm’s Response to an Input Price Change

• The response of a firm to a change in input price:

– When the marginal cost of production increases (from

MC1 to MC2), the level of output that maximizes the profit

falls (from q1 to q2).

– When the price of its product changes, the firm changes

its output level to ensure that marginal cost of production

remains equal to price.


The Firm‘s Response to an Input Price Change

MC2

q2

When the marginal

cost of production for

a firm increases (from

MC1 to MC2), the level

of output that

maximizes profit falls

(from q1 to q2).

MC1

q1 Output

5

Savings of

the company

by reducing

quantity

produced

Price

(€ per unit)


The Short-Run Market Supply Curve

MC3

0 2 8 10 5 7 15 21

MC1

S

The short-run industry supply curve is the summation of

the supply curves of the individual firms.

Quantitiy

MC2

P1

P3

P2

As price rises, all firms expand

their output. This additional

output increases the demand for

inputs to production and may lead

to higher prices. What influence

does this increase have on the

industry's supply ?

Price

(€per unit)


Producer Surplus in the Short Run

• Producer surplus in the short run

– If marginal cost is rising, the rice of the product is greater

than the marginal cost for every unit produced except the

last one. As a result, firms earn surplus on all but the last

unit of output.

– Producer surplus of a firm is the sum of over all units

produced of the differences between the market price of

the good and the marginal cost of production.


Producer Surplus in the Short-Run

A

D

B

C

Producer Surplus

Alternatively, VC is the sum of MC,

respectively 0DCq*. R is equal to P x q*,

respectively 0ABq*. Producer surplus =

R– AC respectively ABCD.

Price

(€ per unit

of output)

Output

AVC MC

0

Price = MR

q*

In q* MC = MR.

Between 0 and q

MR > MC for all units.


Producer Surplus in the Short-Run

• Producer surplus in the short run

Producer Surplus PS R - VC

Profits R - VC - FC


Producer Surplus for a Market

D

P*

Q*

Producer Surplus

The producer surplus for a

market is the area below the

market price and above the

market supply curve, between

output levels 0 and Q*.

Price

(€ per unit

of output)

Output

S

0


Choosing Output in the Long-Run

• In the long-run, a firm can alter all its inputs, including plant

size.

• We assume that there is free entry and exit into and out of

the market.



q1

A

B C

D

Price

(€ per unit

of output)

Output

P = MR €40

SAC

SMC

In the long run the size of production would be expanded to the

output q3. Long-run profit EFGD > short run profit ABCD.

q3 q2

G F

€30

LAC

E

LMC



q1

A

B C

D

Price

(€ per unit

of output)

Output

P = MR €40

SAC

SMC

If the price drops to €30, profits are zero

q3 q2

G F

€30

LAC

E

LMC



• Zero profit means that the firm is earning a normal-i.e.,

competitive-return on its investment.

– if E > wL + rK, the economic profit is positive.

– if E = wL + rK, economic profit is zero, but the firm

makes normal rate of return indicating that the firm is

competitive.

– if E < wL + rK, the firm should consider shutting

down.

Long-Run Competitive Equilibrium



Market Entry and Market Exit

– The long-run response to short-run profits is by

increasing the quantity of goods produced.

– High returns cause investors to enter a certain

market.

– Eventually the increased production associated

with new entry causes the market supply curve

to shift to the right. As a result, market output

increases and the market price of the product

falls.




S1

Output Output

$40 LAC

LMC

D

S2

P1

Q1 q2

Firm Industry

$30

Q2

P2

•Profits attract firms

•Supply increases until profit = 0 Price

(€ per unit

of output) Price

(€ per unit

of output)



• Long-Run Market Equilibrium: all firms in an industry are

maximizing profit, no firm has an incentive to enter or exit,

and price is such that quantity supplied equals quantity

demanded.

1) MC = MR

2) P = LAC

There is no incentive to enter or leave the market.

Profits = 0

3) Market Equilibrium Price



Economic Rent

Amount that firms are willing to pay for an input less the

minimum amount necessary to obtain it.

• In competitive markets, in both the short and the long run,

economic rent is often positive even though profit is zero.



• Example

– Two firms A & B

– Both own their land outright; so that the cost of owning the

land is zero

– A is located on a river and can ship its product for €10,000 a

year less than firm B, which is inland.

– In this case, the €10,000 higher profit of firm A is due to

€10,000 per year economic rent associated with its river

location. The rent is created because the land along the

river is valuable and other firms would be willing to pay for it.

– Due to an increase in the demand for riverfront property,

the price of A’s property increases by €10,000.



• An Example

– Economic rent = €10,000

€10,000 – (no costs due to owning the property)

– The economic rent increases.

– Economic profits decrease to zero.


Firms Earn Zero Profit in Long-Run Equlibrium

Ticket

price

ticket sales

(100,000)

LAC

€7

1.0

A football team in a moderate-sized city

sells enough tickets so that the price (€7) is equal

to the long-run marginal and average costs (profit = 0).

LMC



1.3

€10

Economic Rent

Ticket

price

€7

LAC

A team with the same

cost curve, but in a

larger city, sells tickets

can afford to sell tickets

for € 10.

Season ticket

sales (in100.000)

LMC



• For a fixed input, e.g., the difference between production

costs (LAC = 7) and price (€ 10) corresponds to the value

of the opportunity cost of the input (the site/location) and

also represents the economic rent from the input.

• When the opportunity cost associated with owning the

franchise is taken into account, the team earns zero

economic profit : Economic profit = zero


Effect of an Output Tax t on a Competitive Firm‘s Output

Price

(€ per unit

of output)

Output

AVC1

MC1

P1

q1

The firm will reduce

its output to the

point at which the

marginal cost plus

the tax is equal to

the price of the

product.

q2

t

MC2 = MC1 + tax

AVC1+ tax An output tax raises

the firm’s marginal

cost curve by the

amount of the tax.


Effect of an Output Tax t on Industry Output

Output

D

P1

S1

Q1

P2

Q2

S2 = S1 + t

t An output tax shifts the

supply curve from S1 to

S2; this raises the market

price of the product to P2

and lowers the total output

of the industry to Q2.

Price

(€ per unit

of output)


For discussion…

Ergo: Job cuts despite record profits (ver.di online)

12 March 2013 | Ver.di criticized the planned and ongoing job cuts at the Ergo

insurance group that were being carried out despite record profits. Ergo is part of the

Munich Reinsurance Company Munich Re, which recorded gains of € 3.2 billion last

year.

According to ver.di, Federal President Beate Mensch opined that a reduction in the

number of employees at Ergo is not justified in view of the profits of Munich Re. A

company with such profitability is not justified in jeopardizing the employment of its

employees. The trade union called on the Ergo board to carry out a turnaround in the

ongoing negotiations with the works councils for approximately 1,500 employees

affected by the job cuts.

Ver.di also rejects an increase in the dividend from €6.25 to €7.00. Almost half of the

funds—which would normally be paid to shareholders as dividends—could stop the

staff cuts or at least postpone them until many of the employees had been

transferred into the pension plan.

Beate Mensch also criticized the fact that the remuneration of the Supervisory Board

was going to be increased. This is difficult to understand in light of the lay-offs.

8. profit maximization and competitive supply · 8. profit maximization and competitive supply...

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