chapter 8

Chapter 8Profit Maximization

and Competitive Supply

Profit Maximization and Competitive

Supply

Chapter 8 Slide 2

Topics to be Discussed

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

Choosing Output in the Short-Run

Chapter 8 Slide 3

Topics to be Discussed

The Competitive Firm’s Short-Run Supply Curve

Short-Run Market Supply

Choosing Output in the Long-Run

The Industry’s Long-Run Supply Curve

Chapter 8 Slide 4


Characteristics of Perfectly Competitive Markets

1) Price taking

2) Product homogeneity

3) Free entry and exit

Chapter 8 Slide 5


Price Taking

The individual firm sells a very small share of the total market output and, therefore, cannot influence market price.

The individual consumer buys too small a share of industry output to have any impact on market price.

Chapter 8 Slide 6


Product Homogeneity

The products of all firms are perfect substitutes.

Examples

Agricultural products, oil, copper, iron, lumber

Chapter 8 Slide 7


Free Entry and Exit

Buyers can easily switch from one supplier to another.

Suppliers can easily enter or exit a market.

Chapter 8 Slide 8

Profit Maximization

Do firms maximize profits?

Possibility of other objectivesRevenue maximizationDividend maximization

Chapter 8 Slide 9

Profit Maximization

Do firms maximize profits?

Implications of non-profit objectiveOver the long-run investors would not

support the companyWithout profits, survival unlikely

Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior.

Chapter 8 Slide 10

Marginal Revenue, Marginal Cost,and Profit Maximization

Determining the profit maximizing level of outputProfit ( ) = Total Revenue - Total Cost

Total Revenue (R) = Pq

Total Cost (C) = Cq

Therefore:

)()()( qCqRq

Chapter 8 Slide 11

Marginal revenue is the additional revenue from producing one more unit of output.

Marginal cost is the additional cost from producing one more unit of output.


Chapter 8 Slide 12

Comparing R(q) and C(q)

Output levels: 0- q0:

C(q)> R(q) Negative profit

FC + VC > R(q) MR > MC

Indicates higher profit at higher output 0

Cost,Revenue,

Profit($s per year)

Output (units per year)

R(q)

C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 13

Comparing R(q) and C(q) Question: Why is profit

negative when output is zero?


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 14


Output levels: q0 - q*

R(q)> C(q) MR > MC

Indicates higher profit at higher output

Profit is increasing

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 15


Output level: q*

MR = MC Profit is maximized

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 16


Output levels beyond q*: MC > MR Profit is decreasing


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 17

C - R


q

R MR

q

CMC

Chapter 8 Slide 18

orq

C

q

R 0

q

: whenmaximized are Profits

MC(q)MR(q)

MCMR

thatso0


Chapter 8 Slide 19

The Competitive Firm

Price taker

Market output (Q) and firm output (q)

Market demand (D) and firm demand (d)

R(q) is a straight line


Demand and Marginal Revenue Facedby a Competitive Firm

Output (bushels)

Price$ per bushel

Price$ per bushel

Output (millions of bushels)

d$4

100 200 100

Firm Industry

D

$4

Chapter 8 Slide 21


The competitive firm’s demand Individual producer sells all units for $4

regardless of the producer’s level of output.

If the producer tries to raise price, sales are zero.


Chapter 8 Slide 22


AR = MR = P

Profit MaximizationMC(q) = MR = P


Chapter 8 Slide 23

Choosing Output in the Short Run

We will combine production and cost analysis with demand to determine output and profitability.

Chapter 8 Slide 24

q0

Lost profit forq1 < q*

Lost profit forq2 > q*

q1 q2

A Competitive FirmMaking a Positive Profit

10

20

30

40

Price($ per

unit)

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

50

60MC

AVC

ATCAR=MR=P

Outputq*

At q*: MR = MCand P > ATC

ABCDor

qx ATC) -(P *

D A

BC

q1 : MR > MC andq2: MC > MR andq*: MC = MR but

MC falling

Chapter 8 Slide 25

Would this producercontinue to produce with a loss?

A Competitive FirmIncurring Losses

Price($ per

unit)

Output

AVC

ATCMC

q*

P = MR

B

F

C

A

E

DAt q*: MR = MCand P < ATCLosses = (P- ATC) x q* or ABCD

Chapter 8 Slide 26

Choosing Output in the Short Run

Summary of Production Decisions

Profit is maximized when MC = MR

If P > ATC the firm is making profits.

If AVC < P < ATC the firm produces at a loss.

If P < AVC < ATC the firm should shut-down.

Chapter 8 Slide 27

A Competitive Firm’sShort-Run Supply Curve

Price($ per

unit)

Output

MC

AVC

ATC

P = AVCWhat happens

if P < AVC?

P2

q2

P1

q1

The firm chooses theoutput level where MR = MC,as long as the firm is able to

cover its variable cost of production.

Chapter 8 Slide 28

Observations:P = MRMR = MCP = MC

Supply is the amount of output for every possible price. Therefore:If P = P1, then q = q1

If P = P2, then q = q2


Chapter 8 Slide 29

Price($ per

unit)

MC

Output

AVC

ATC

P = AVC

P1

P2

q1 q2

S = MC above AVC


Shut-down

Chapter 8 Slide 30

Observations:Supply is upward sloping due to

diminishing returns.

Higher price compensates the firm for higher cost of additional output and increases total profit because it applies to all units.


Chapter 8 Slide 31

Firm’s Response to an Input Price ChangeWhen the price of a firm’s input changes,

the firm changes its output level, so that the marginal cost of production remains equal to the price.


Chapter 8 Slide 32

MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input Price

Price($ per

unit)

Output

$5

Savings to the firmfrom reducing output

Chapter 8 Slide 33

MC3

Industry Supply in the Short Run

$ perunit

0 2 4 8 105 7 15 21

MC1

SSThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Quantity

MC2

P1

P3

P2

Chapter 8 Slide 34

Producer Surplus in the Short RunFirms earn a surplus on all but the last unit

of output.

The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production.

The Short-Run Market Supply Curve

Chapter 8 Slide 35

AA

DD

BB

CC

ProducerProducerSurplusSurplus

Alternatively, VC is thesum of MC or ODCq* .R is P x q* or OABq*.Producer surplus =

R - VC or ABCD.

Producer Surplus for a Firm

Price($ per

unit ofoutput)

Output

AVCAVCMCMC

00

PP

qq**

At q* MC = MR.Between 0 and q ,

MR > MC for all units.

Chapter 8 Slide 36

Producer Surplus in the Short-Run

Profit = R - VC - FC

Profit < producer surplus

The Short-Run Market Supply Curve

VC- R PS Surplus Producer

Chapter 8 Slide 37

DD

PP**

QQ**

ProducerProducerSurplusSurplus

Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a Market

Price($ per

unit ofoutput)

Output

SS

Chapter 8 Slide 38

Choosing Output in the Long Run

In the long run, a firm can alter all its inputs, including the size of the plant.

We assume free entry and free exit.

Chapter 8 Slide 39

q1

A

BC

D

In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.Profit is equal to ABCD.

Output Choice in the Long Run

Price($ per

unit ofoutput)

Output

P = MR$40

SACSMC

In the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

q3q2

G F$30

LAC

E

LMC

Chapter 8 Slide 40


Accounting Profit & Economic ProfitAccounting profit = R - wL

Economic profit = R - wL - rKwl = labor cost

rk = opportunity cost of capital

)()(

Chapter 8 Slide 41


Zero-ProfitIf R > wL + rk, economic profits are positive

If R = wL + rk, zero economic profits, but the firms is earning a normal rate of return; indicating the industry is competitive

If R < wl + rk, consider going out of business

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

Chapter 8 Slide 42


Entry and ExitThe long-run response to short-run profits

is to increase output.

Profits will attract other producers.

More producers increase industry supply which lowers the market price.

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

S1

Long-Run Competitive Equilibrium

Output Output

$ per unit ofoutput

$ per unit ofoutput

$40LAC

LMC

D

S2

P1

Q1q2

Firm Industry

$30

Q2

P2

•Profit attracts firms•Supply increases until profit = 0

Chapter 8 Slide 44


Long-Run Competitive Equilibrium

1) MC = MR

2) P = LAC

No incentive to leave or enter

Profit = 0

3) Equilibrium Market Price

AP1

AC

P1

MC

q1

D1

S1

Q1

C

D2

P2P2

q2

B

S2

Q2

Economic profits attract newfirms. Supply increases to S2 and

the market returns to long-run equilibrium.

Long-Run Supply in aConstant-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

SL

Q1 increase to Q2.Long-run supply = SL = LRAC.

Change in output has no impact on input cost.

Chapter 8 Slide 46

In a constant-cost industry, long-run supply is a horizontal line

Long-Run Supply in aConstant-Cost Industry

Long-Run Supply in anIncreasing-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput S1

D1

P1

AC1

P1

MC1

q1 Q1

A

SSLL

P3

MC2

Due to the increasein input prices, long-runequilibrium occurs at

a higher price.

AC2

B

S2

P3

Q3q2

P2 P2

D2

Q2

Chapter 8 Slide 48

In a increasing-cost industry, long-run supply curve is upward sloping.

Long-Run Supply in aIncreasing-Cost Industry

S2

B

SL

P3

Q3

MC2

P3

AC2

Due to the decreasein input prices, long-runequilibrium occurs at

a lower price.

Long-Run Supply in anDecreasing-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

P1P1

MC1

A

D1

S1

Q1q1

AC1

Q2q2

P2 P2

D2

Chapter 8 Slide 50

In a decreasing-cost industry, long-run supply curve is downward sloping.

Long-Run Supply in aIncreasing-Cost Industry

Chapter 8 Slide 51

The Effects of a TaxIn an earlier chapter we studied how firms

respond to taxes on an input.

Now, we will consider how a firm responds to a tax on its output.

The Industry’sLong-Run Supply Curve

Chapter 8 Slide 52

Effect of an Output Tax on a Competitive Firm’s Output

Price($ per

unit ofoutput)

Output

AVC1

MC1

P1

q1

The firm willreduce output to

the point at whichthe marginal cost

plus the tax equalsthe price.

q2

tt

MC2 = MC1 + tax

AVC2

An output taxraises the firm’s

marginal cost by theamount of the tax.

Chapter 8 Slide 53

Effect of an OutputTax on Industry Output

Price($ per

unit ofoutput)

Output

DD

P1

SS1

Q1

P2

Q2

SS2 = S1 + t

t

Tax shifts S1 to S2 andoutput falls to Q2. Price

increases to P2.

Chapter 8 Slide 54

Summary

The managers of firms can operate in accordance with a complex set of objectives and under various constraints.

A competitive market makes its output choice under the assumption that the demand for its own output is horizontal.

Chapter 8 Slide 55

Summary

In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost.

The short-run market supply curve is the horizontal summation of the supply curves of the firms in an industry.

Chapter 8 Slide 56

Summary

The producer surplus for a firm is the difference between revenue of a firm and the minimum cost that would be necessary to produce the profit-maximizing output.

Chapter 8 Slide 57

Summary

In the long-run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost.

The long-run supply curve for a firm can be horizontal, upward sloping, or downward sloping.

End of Chapter 8

chapter 8

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