PROFIT MAXIMIZATION UNDER PROFIT MAXIMIZATION UNDER COMPETITIVE MARKET COMPETITIVE MARKET
CONDITIONSCONDITIONS
PROFIT MAXIMIZATION UNDER PROFIT MAXIMIZATION UNDER COMPETITIVE MARKET COMPETITIVE MARKET
CONDITIONSCONDITIONS
EA SESSION 8EA SESSION 8
18th July 200518th July 2005
Prof. Samar K. DattaProf. Samar K. Datta
EA SESSION 8EA SESSION 8
18th July 200518th July 2005
Prof. Samar K. DattaProf. Samar K. Datta
2
Sub-topics to be covered
• Perfectly Competitive Markets
• Profit Maximization
• Marginal Revenue, Marginal Cost, and Profit Maximization
• Choosing Output in the Short-Run
• 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 – Can it be less elastic?
3
MODELS OF MARKET STRUCTURE
Market Structure
Atomistic Competition Non-Atomistic Competition
Perfect Competition
Monopolistic Competition
Oligopoly Duopoly Monopoly
Conjectural Variation = 0 Conjectural Variation 0
4
Perfectly Competitive Markets
• Characteristics of Perfectly Competitive Markets
1) Price taking
2) Product homogeneity
3) Free entry and exit
5
• Question
– Why is profit reduced when producing more or less than q*?
R(q)
0
Cost,Revenue,
Profit$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(q
Marginal Revenue, Marginal Cost,and Profit Maximization
Demand and Marginal Revenue Faced
by a Competitive Firm
Output (bushels)
Price$ per bushel
Price$ per bushel
Output (millions of bushels)
d$4
100 200 100
Firm Industry
D
$4
7
q0
Lost profit forqq < q*
Lost profit forq2 > q*
q1 q2
A Competitive FirmMaking a Positive Profit
10
20
30
40
Price($ 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 AC) -(P *
D A
BC
q1 : MR > MC andq2: MC > MR andq0: MC = MR but
MC falling
8
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- AC) x q* or ABCD
9
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 should produce at a loss.
– If P < AVC < ATC the firm should shut-down.
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Price($ per
unit)
MC
Output
AVC
ATC
P = AVC
P1
P2
q1 q2
S = MC above AVC
A Competitive Firm’sShort-Run Supply Curve
Shut-down
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• 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.
– Firm’s response to an input price change
• When 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.
A Competitive Firm’sShort-Run Supply Curve
12
The Short-Run Productionof Petroleum Products
Cost($ per
barrel)
Output(barrels/day)
8,000 9,000 10,000 11,000
23
24
25
26
27 SMC
How much wouldbe produced if
P = $23? P = $24-$25?
The MC of producinga mix of petroleum products
from crude oil increasessharply at several levelsof output as the refinery
shifts from one processingunit to another.
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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
Question: If increasingoutput raises inputcosts, what impactwould it have on market supply?
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• Perfectly inelastic (vertical) short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output.
• Perfectly elastic (horizontal) short-run supply arises when marginal costs are constant.
The Short-Run Market Supply Curve
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• Producer Surplus in the Short Run– Firms 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
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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.
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• Producer Surplus in the Short-Run
• Observation
– Short-run with positive fixed cost
The Short-Run Market Supply Curve
VC- R PS Surplus Producer
FC - VC- R Profit
PS
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q1
A
BC
D
In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.Profit is equal to ABCD.
Output Choice in the Long RunPrice
($ perunit of
output)
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
Can this firm stay indefinitely at E?
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Choosing Output in the Long Run
• Entry and Exit– The long-run response to short-run
profits is to increase output and profits.– 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
21
Choosing Output in the Long Run
• 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 a
Constant-Cost Industry is a horizontal line
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.
1
2
1
2
3Sequence of eventsshown by numbersIn both diagrams
Long-Run Supply in anIncreasing-Cost Industry is upward sloping
Output Output
$ per unit ofoutput
$ per unit ofoutput S1
D1
P1
LAC1
P1
SMC1
q1 Q1
A
SSLL
P3
SMC2
Due to the increasein input prices, long-runequilibrium occurs at
a higher price.
LAC2
B
S2
P3
Q3q2
P2 P2
D1
Q2
1
2
1
2
3
Sequence of eventsshown by numbersIn both diagrams
S2
B
SL
P3
Q3
SMC2
P3
LAC2
Due to the decreasein input prices, long-runequilibrium occurs at
a lower price.
Long-Run Supply in anDecreasing-Cost Industry is downward sloping
Output Output
$ per unit ofoutput
$ per unit ofoutput
P1P1
SMC1
A
D1
S1
Q1q1
LAC1
Q2q2
P2 P2
D2
Sequence of eventsshown by numbersIn both diagrams
1
21
2
3
25
Effect of an Output Tax on a Competitive Firm’s Output (Is the drawing perfectly correct?)
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.
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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.
Note how the burden of tax is generally borne by both parties
