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The Competitive Firm
Chapter 7
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The Profit Motive
• The basic incentive for producing goods
and services is the expectation of profit.
• Profit is the difference between total
revenue and total cost.
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Other Motivations
• Personal reasons also motivate producers.
– Producers seek social status and crave
recognition.
– Non-owner managers of corporations may be
more interested in their own jobs, salaries, and
self-preservation than earning profits for
stockholders.
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Is the Profit Motive Bad?
• The profit motive encourages businesses
to produce the goods and services
consumers’ desire, at prices they are
willing to pay.
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Economic vs. Accounting Profits
• The typical consumer believes that 35¢ of
every sales dollar goes to profits.
• In reality, average profit per sales dollar is
closer to 5¢.
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Economic Profits
• Economic profit is the difference between
total revenues and total economic costs.
• Economic cost is the value of all
resources used to produce a good or
service – opportunity cost.
Economic
Total
Total economic
=
–
profit
revenue
cost
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Economic Profits
• To determine a firm’s economic profit, all
implicit factor costs must be subtracted
from observed accounting profit.
Economic = Accounting - Implicit
profit
profit
costs
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Economic Profits
• Normal profit is the opportunity cost of
capital – zero economic profit.
• Economic profits represent something over
and above normal profits.
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Economic Profits
• A productive activity reaps an economic
profit only if it earns more than its
opportunity cost.
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Economic Profits
Total (gross) revenues
$27,000
less explicit costs:
Cost of merchandise sold
$17,000
Wages to cashier, stock, and delivery help
2,500
Rent and utilities
800
Taxes
700
Total explicit costs
$21,000
Accounting profit (revenue minus explicit costs)
$ 6,000
less implicit costs
Wages of owner-manager, 300 hours @ $10 per hour
Return on inventory investment, 10% per year on $120,000
Total implicit costs
1,000
$ 4,000
Economic profit (revenue minus all costs)
McGraw-Hill/Irwin
$ 3,000
$ 2,000
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Entrepreneurship
• The inducement to take on the added
responsibilities of owning and operating a
business is the potential for profit.
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Risk
• The potential for profit is not a guarantee of
profit.
• Substantial risks are attached to starting
and operating a business.
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Market Structure
• The opportunity for profit may be limited by
the structure of the industry.
• Market structure is the number and
relative size of firms in an industry.
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Market Structure
• Perfect competition is market in which no
buyer or seller has market power.
• Monopoly is a firm that produces the
entire market supply of a particular good or
service.
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Market Structure
Imperfect competition
Perfect
Monopolistic Oligopoly
competition competition
McGraw-Hill/Irwin
Duopoly
Monopoly
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The Nature of Perfect
Competition
• A perfectly competitive industry has
several distinguishing characteristics:
– Many firms – lots of firms are competing for
consumer purchases.
– Identical products – the products of the
different firms are identical, or nearly so.
– Low entry barriers – it’s relatively easy to get
into the business.
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Price Takers
• A perfectly competitive firm has no
market power and has no ability to alter the
market price of the goods it produces.
– Market Power - The ability to alter the market
price of a good or service.
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Price Takers
• The output of a perfectly competitive firm is
so small relative to market supply that it
has no significant effect on the total
quantity or price in the market.
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Market Demand Curves vs.
Firm Demand Curves
• It is important to distinguish between the
market demand curve and the demand
curve confronting a particular firm.
• While the actions of a single competitive
firm are negligible, the unified actions of
many such firms are not.
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Market Demand Curves vs.
Firm Demand Curves
• The market demand curve for a product is
always downward-sloping.
• The demand curve confronting a perfectly
competitive firm is horizontal.
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Market Demand Curves vs.
Firm Demand Curves
The T-shirt market
Demand facing one shop
PRICE (per shirt)
Market supply
pe
Equilibrium
price
pe
Demand facing
single firm
Market demand
Quantity (thousand shirts per day)
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Quantity (shirts per day)
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The Production Decision
• A competitive firm has only one decision to
make: how much to produce.
• The production decision is the selection
of the short-run rate of output (with existing
plant and equipment).
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Output and Revenues
• In searching for the most desirable rate of
output, the distinction between total
revenue and total profit must be kept in
mind.
– Total revenue - The price of the good
multiplied by the quantity sold in a given time
period.
Total revenue = price X quantity
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Output and Revenues
• The total revenue curve of a perfectly
competitive firm is an upward-sloping
straight line, with a slope equal to pe.
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Price Quantity
$8
8
8
8
8
8
8
8
8
1
2
3
4
5
6
7
8
9
McGraw-Hill/Irwin
Total
Revenue
$ 8
16
24
32
40
48
56
64
72
Total Revenue
Total Revenue
$96
88
80
72
64
56
48
40
32
24
16
8
0
Total revenue
pe= $8
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
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Output and Costs
• To maximize profits a firm must consider
how increased production will affect costs
as well as revenues.
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Output and Costs
• Producers are saddled with certain costs in
the short-run.
– Short-run - The period in which the quantity
(and quality) of some inputs cannot be
changed.
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Output and Costs
• Fixed costs are incurred even if no output
is produced.
– Fixed costs - Costs of production that do not
change when the rate of output is altered, e.g.,
the cost of basic plant and equipment.
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Output and Costs
• Once a firm starts producing output, it
incurs variable costs as well.
– Variable costs - Costs of production that
change when the rate of output is altered, e.g.
labor and material costs.
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Total Cost (dollars per time period)
Total Cost
Total cost
z
Total costs escalate due to the
law of diminishing returns
Fixed cost
Output (units per time period)
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Output and Costs
• The shape of the total cost curve reflects
increasing marginal costs and the law of
diminishing returns.
– Marginal cost is the increase in total costs
associated with a one-unit increase in
production.
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Output and Costs
• The primary objective of the producer is to
find that one particular rate of output that
maximizes profits.
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Revenues Or Costs (dollars per period)
Total Profit
Total cost
Total revenue
r
s
f
h
g
Output (units per period)
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Profit-Maximizing Rule
• The best single rule for maximizing shortrun profits is straightforward:
• Never produce a unit of output that costs
more than it brings in.
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Marginal Revenue = Price
• The contribution to total revenue of an
additional unit of output is called marginal
revenue.
• For perfectly competitive firms, price
equals marginal revenue.
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Marginal Revenue = Price
• Marginal revenue (MR) is the change in
total revenue that results from a one-unit
increase in the quantity sold.
Marginal Change in total revenue
=
revenue
Change in output
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Marginal Revenue = Price
Rate of
Output
0
1
2
3
4
5
McGraw-Hill/Irwin
Price
$13
13
13
13
13
13
Total
Revenue
$0
13
26
39
52
65
Marginal
Revenue
$13
13
13
13
13
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Marginal Cost
• A firm’s goal is not to maximize revenues,
but to maximize profits.
• Marginal revenue is compared to marginal
costs to determine the best level of output.
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Marginal Cost
• What an additional unit of output brings in
is its marginal revenue (MR).
• What it costs to produce is its marginal
cost (MC).
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Marginal Cost
Rate of
Output
0
1
2
3
4
5
McGraw-Hill/Irwin
Total Cost
Marginal
Cost
Average
Cost
$10
15
22
31
44
61
$ 5
7
9
13
17
$15.00
11.00
10.33
11.00
12.20
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Profit-Maximizing Rate of
Output
• According to the profit-maximization rule
a firm should produce at that rate of output
where marginal revenue equals marginal
cost.
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Profit-Maximizing Rate of
Output
• If marginal cost exceeds price, total profits
decline if the additional output is produced.
• If marginal cost is less than price, total
profits increase if the additional output is
produced.
• Profits are maximized at the rate of output
where price equals marginal cost.
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Short-Run Profit-Maximization
Rules for Competitive Firm
Price > MC  increase output
Price = MC  maintain output and
maximize profit
Price < MC  decrease output
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Profit-Maximizing Rate of
Output
$18
Marginal cost
Price or Cost (per bushel)
16
14
p = MC
MRB
12
10
Profits decreasing
Price (= MR)
Profits increasing
8
Profit-maximizing
rate of output
6
4
MCB
2
0
McGraw-Hill/Irwin
1
2
3
4
5
Quantity (bushels per day)
6
7
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Adding Up Profits
• Profits can be computed in two ways.
• Total profit is the difference between total
revenue and total cost.
Total profit = total revenue – total cost
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Adding Up Profits
• Total profit is average profit times the
number sold.
Profit per unit = price – ATC
Total profit = profit per unit X quantity
Total profit = (p – ATC) X q
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Adding Up Profits
• The profit-maximizing producer never
seeks to maximize per-unit profits.
• What counts is total profits, not the amount
of profit per unit.
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Adding Up Profits
• The profit-maximizing producer has no
desire to produce at that rate of output
where ATC is at a minimum.
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Alternative Views of Total Profit
Price and average cost
Revenue or Cost (dollars per day)
$90
80
70
60
50
40
30
20
10
0
Total revenue
Maximum
total profit
Total cost
1
2 3 4 5
Rate of Output
McGraw-Hill/Irwin
6
7
Price or Cost (per unit)
Total revenue and total cost
$18
16
14
12
10
8
6
4
2
0
Average total
cost
Total Profit
Marginal cost
1
Price
Profit per
unit
Cost per unit
2 3 4 5
Rate of Output
6
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7
The Shutdown Decision
• The short-run profit maximization rule does
not guarantee any profits.
• Fixed costs must be paid even if all output
ceases.
• A firm should shut down only if the losses
from continuing production exceed fixed
costs.
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Price vs. AVC
• Where price exceeds average variable cost
but not average total cost, the profit
maximizing rule minimizes losses.
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The Shutdown Point
• When price does not cover average
variable costs at any rate of output,
production should cease.
• The shutdown point is that rate of output
where price equals minimum AVC.
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The Shutdown Point
Profit
Price or Cost
18
16
14
Loss
MC
ATC
X
12
10
Price
(=MR
)
AVC
Shutdown
MC
ATC
AVC
Price
Y
8
6
4
MC
ATC
AVC
Price
shutdown point
2
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity
McGraw-Hill/Irwin
Quantity
Quantity
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The Investment Decision
• The investment decision is the decision
to build, buy, or lease plant and equipment.
• It also involves the decision to enter or exit
an industry.
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The Investment Decision
• The shut-down decision is a short-run
response.
• Investment decisions are long-run
decisions.
– Long-run – A period of time long enough for
all inputs to be varied (no fixed costs).
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Long-Run Costs
• In making long-run decisions, the producer
is confronted with many possible cost
figures.
• A producer will want to build, buy or lease
a plant that is most efficient for the
anticipated rate of output.
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Determinants of Supply
• The quantity of a good supplied is affected
by all forces that alter marginal cost.
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Short-Run Determinants
• The determinants of a firm’s supply
include:
– The price of factor inputs.
– Technology (the available production
function).
– Expectations (for costs, sales, technology).
– Taxes and subsidies.
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Short-Run Supply Curve
• The marginal cost curve is the short-run
supply curve for a competitive firm.
– Supply curve – A curve describing the
quantities of a good a producer is willing and
able to sell (produce) at alternative prices in a
given time period, ceteris paribus.
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Price (per bushel)
Short-Run Supply Curve
$18
16
14
12
10
8
6
4
2
X
Shutdown
point
0
Y
Marginal cost
curve
1
2
3
=
Short-run supply curve
for competitive firm
4
5
6
7
Quantity Supplied (bushels per day)
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Supply Shifts
• If any determinant of supply changes, the
supply curve shifts.
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Tax Effects
• Some tax changes alter short-run supply
behavior.
• Others affect only long-run supply
decisions.
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Property Taxes
• Property taxes are a fixed cost.
• They raise average costs and reduce
profit.
• Because they don’t affect marginal costs,
they leave the profit-maximizing output
unchanged.
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Payroll Taxes
• Payroll taxes increase marginal costs.
• They reduce the profit maximizing rate of
output.
• They increase average costs and lower
total and per-unit profits.
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Profit Taxes
• Profit taxes are neither a fixed cost nor a
variable cost.
• They don’t affect marginal cost or prices.
• They don’t affect production level decisions
but may affect investment decisions.
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Impact of Taxes on Business
Decisions
Property taxes
affect fixed costs
MC1
ATCa
ATC1
pe
Payroll taxes
alter marginal
costs
Profits taxes
don't change
costs
MCb
MC1
MC1
ATCb
ATC1
pe
q1
McGraw-Hill/Irwin
ATC1
pe
qb q1
q1
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The Competitive Firm
End of Chapter 7
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