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Chapter 8
Profit Maximization
and Competitive
Supply
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 2
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 3
Perfectly Competitive Markets

Characteristics of Perfectly Competitive
Markets
1) Price taking
2) Product homogeneity
3) Free entry and exit
Chapter 8
Slide 4
Perfectly Competitive Markets

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 5
Perfectly Competitive Markets

Product Homogeneity
 The
products of all firms are perfect
substitutes.
 Examples

Chapter 8
Agricultural products, oil, copper, iron,
lumber
Slide 6
Perfectly Competitive Markets

Free Entry and Exit
 Buyers
can easily switch from one supplier
to another.
 Suppliers
Chapter 8
can easily enter or exit a market.
Slide 7
Profit Maximization

Do firms maximize profits?
 Possibility
Chapter 8
of other objectives

Revenue maximization

Dividend maximization
Slide 8
Profit Maximization

Do firms maximize profits?
 Implications
of non-profit objective

Over the long-run investors would not
support the company

Without profits, survival unlikely
 Long-run
profit maximization is valid and
does not exclude the possibility of
altruistic behavior.
Chapter 8
Slide 9
Marginal Revenue, Marginal Cost,
and Profit Maximization

Determining the profit maximizing level
of output

Profit (  ) = Total Revenue - Total Cost

Total Revenue (R) = Pq

Total Cost (C) = Cq

Therefore:
 (q)  R(q)  C (q)
Chapter 8
Slide 10
Marginal Revenue, Marginal Cost,
and Profit Maximization

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 11
Marginal Revenue, Marginal Cost,
and Profit Maximization

Comparing R(q) and C(q)

Output levels: 0- q0:

C(q)> R(q)

C(q)
FC + VC > R(q)

MR > MC
Indicates higher
profit at higher
output
R(q)
A
Negative profit


Cost,
Revenue,
Profit
($s per year)
B
0
q0
q*
 (q)
Output (units per year)
Chapter 8
Slide 12
Marginal Revenue, Marginal Cost,
and Profit Maximization

Comparing R(q) and C(q)

Question: Why is profit
negative when output is
zero?
Cost,
Revenue,
Profit
$ (per year)
C(q)
R(q)
A
B
0
q0
q*
 (q)
Output (units per year)
Chapter 8
Slide 13
Marginal Revenue, Marginal Cost,
and Profit Maximization

Comparing R(q) and C(q)

Output levels: q0 - q*


R(q)> C(q)
Cost,
Revenue,
Profit
$ (per year)
C(q)
R(q)
A
MR > MC


Indicates higher
profit at higher
output
Profit is increasing
B
0
q0
q*
 (q)
Output (units per year)
Chapter 8
Slide 14
Marginal Revenue, Marginal Cost,
and Profit Maximization

Comparing R(q) and C(q)

Output level: q*


MR = MC
Cost,
Revenue,
Profit
$ (per year)
C(q)
R(q)
A
Profit is maximized
B
0
q0
q*
 (q)
Output (units per year)
Chapter 8
Slide 15
Marginal Revenue, Marginal Cost,
and Profit Maximization

Comparing R(q) and C(q)

Output levels beyond q*:


MC > MR
Cost,
Revenue,
Profit
$ (per year)
C(q)
R(q)
A
Profit is decreasing
B
0
q0
q*
 (q)
Output (units per year)
Chapter 8
Slide 16
Marginal Revenue, Marginal Cost,
and Profit Maximization
  R-C
R
MR 
q
C
MC 
q
Chapter 8
Slide 17
Marginal Revenue, Marginal Cost,
and Profit Maximization
Profits are maximized when :
 R C


 0 or
q q q
MR  MC  0 so that
MR(q)  MC(q)
Chapter 8
Slide 18
Marginal Revenue, Marginal Cost,
and Profit Maximization

The Competitive Firm
 Price
taker
 Market
output (Q) and firm output (q)
 Market
demand (D) and firm demand (d)
 R(q)
Chapter 8
is a straight line
Slide 19
Demand and Marginal Revenue Faced
by a Competitive Firm
Price
$ per
bushel
Price
$ per
bushel
Firm
$4
d
Industry
$4
D
100
200
Output
(bushels)
100
Output
(millions
of bushels)
Marginal Revenue, Marginal Cost,
and Profit Maximization

The Competitive Firm
 The
Chapter 8
competitive firm’s demand

Individual producer sells all units for $4
regardless of the producer’s level of
output.

If the producer tries to raise price, sales
are zero.
Slide 21
Marginal Revenue, Marginal Cost,
and Profit Maximization

The Competitive Firm
 AR
= MR = P
 Profit

Chapter 8
Maximization
MC(q) = MR = P
Slide 22
Choosing Output in the Short Run

We will combine production and cost
analysis with demand to determine
output and profitability.
Chapter 8
Slide 23
A Competitive Firm
Making a Positive Profit
MC
Price
60
($ per
unit)
50
40
Lost profit for
q 1 < q*
A
D
Lost profit for
q2 > q*
ATC
C
B
AVC
30
At q*: MR = MC
and P > ATC
q1 : MR > MC and
q2: MC > MR20
and
q*: MC = MR but
MC falling
10
0
  (P - ATC) x q*
or ABCD
1
q0
Chapter 8
AR=MR=P
2
3
4
5
6
7
q1
8
q*
9
q2
10
11
Output
Slide 24
A Competitive Firm
Incurring Losses
MC
Price
($ per
unit)
C
D
At q*: MR = MC
and P < ATC
Losses = (P- ATC) x
q* or ABCD
F
B
A
P = MR
AVC
E
q*
Chapter 8
ATC
Would this producer
continue to produce
with a loss?
Output
Slide 25
Choosing Output in the Short Run

Summary of Production Decisions
 Profit
 If
is maximized when MC = MR
P > ATC the firm is making profits.
 If
AVC < P < ATC the firm produces at a
loss.
 If
P < AVC < ATC the firm should shutdown.
Chapter 8
Slide 26
A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the
output level where MR = MC,
as long as the firm is able to
cover its variable cost of
production.
MC
P2
ATC
P1
AVC
What happens
if P < AVC?
P = AVC
q1
Chapter 8
q2 Output
Slide 27
A Competitive Firm’s
Short-Run Supply Curve


Observations:

P = MR

MR = MC

P = 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 28
A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit)
S = MC above AVC
MC
P2
ATC
P1
AVC
P = AVC
Shut-down
q1
Chapter 8
q2
Output
Slide 29
A Competitive Firm’s
Short-Run Supply Curve

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 30
A Competitive Firm’s
Short-Run Supply Curve

Firm’s Response to an Input Price
Change

Chapter 8
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.
Slide 31
The Response of a Firm to
a Change in Input Price
Price
($ per
unit)
MC2
Input cost increases
and MC shifts to MC2
and q falls to q2.
Savings to the firm
from reducing output
MC1
$5
q2
Chapter 8
q1
Output
Slide 32
Industry Supply in the Short Run
MC1 MC2
$ per
unit
MC3
The short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
P3
P2
P1
0
Chapter 8
2
4 5
7 8
10
15
Quantity 21
Slide 33
S
The Short-Run Market Supply Curve

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.
Chapter 8
Slide 34
Producer Surplus for a Firm
Price
($ per
unit of
output)
At q* MC = MR.
Between 0 and q ,
MR > MC for all units.
Producer
Surplus
MC
AVC
B
A
D
0
Chapter 8
P
C
q*
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
Producer surplus =
R - VC or ABCD.
Output
Slide 35
The Short-Run Market Supply Curve

Producer Surplus in the Short-Run

Profit = R - VC - FC

Profit < producer surplus
Producer Surplus  PS  R - VC
Chapter 8
Slide 36
Producer Surplus for a Market
Price
($ per
unit of
output)
S
Market producer surplus is
the difference between P*
and S from 0 to Q*.
P*
Producer
Surplus
D
Q*
Chapter 8
Output
Slide 37
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 38
Output Choice in the Long Run
Price
($ per
unit of
output)
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
LMC
LAC
SMC
D
SAC
A
E
$40
C
G
P = MR
B
F
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1
Chapter 8
q2
q3
Output
Slide 39
Choosing Output in the Long Run

Accounting Profit & Economic Profit
Accounting profit ( ) = R - wL
 Economic profit ( ) = R - wL - rK

wl
= labor cost
rk =
Chapter 8
opportunity cost of capital
Slide 40
Choosing Output in the Long Run
Long-Run Competitive Equilibrium

Zero-Profit

If 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
Chapter 8
Slide 41
Choosing Output in the Long Run
Long-Run Competitive Equilibrium

Entry and Exit

The 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.
Chapter 8
Slide 42
Long-Run Competitive Equilibrium
•Profit attracts firms
•Supply increases until profit = 0
$ per
unit of
output
$ per
unit of
output
Firm
Industry
S1
LMC
$40
LAC
$30
P1
S2
P2
D
q2
Output
Q1
Q2
Output
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
Chapter 8
Slide 44
Long-Run Supply in a
Constant-Cost Industry
$ per
unit of
output
Economic profits attract new
firms. Supply increases to S2 and
the market returns to long-run
equilibrium.
MC
$ per
unit of
output
Q1 increase to Q2.
Long-run supply = SL = LRAC.
Change in output has no impact on
input cost.
S1
AC
P2
S2
C
P2
A
P1
B
SL
P1
D1
q1 q2
Output
Q1
Q2
D2
Output
Long-Run Supply in a
Constant-Cost Industry

In a constant-cost industry, long-run
supply is a horizontal line
Chapter 8
Slide 46
Long-Run Supply in an
Increasing-Cost Industry
$ per
unit of
output
MC2
AC2
$ per
unit of
output
Due to the increase
in input prices, long-run
equilibrium occurs at
a higher price.
S1 S2
SL
MC1
P2
AC1
P2
P3
P3
P1
P1
B
A
D1
q1 q2
Output
Q1 Q2 Q3
D2
Output
Long-Run Supply in a
Increasing-Cost Industry

In a increasing-cost industry, long-run
supply curve is upward sloping.
Chapter 8
Slide 48
Long-Run Supply in an
Decreasing-Cost Industry
$ per
unit of
output
Due to the decrease
in input prices, long-run
equilibrium occurs at
a lower price.
$ per
unit of
output
S1
S2
MC1
MC2
AC1
P2
P2
AC2
P1
P1
P3
P3
A
B
SL
D1
q1
q2
Output
Q1 Q2
Q3
D2
Output
Long-Run Supply in a
Increasing-Cost Industry

In a decreasing-cost industry, long-run
supply curve is downward sloping.
Chapter 8
Slide 50
The Industry’s
Long-Run Supply Curve

The Effects of a Tax

In 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.
Chapter 8
Slide 51
Effect of an Output Tax on a
Competitive Firm’s Output
Price
($ per
unit of
output)
MC2 = MC1 + tax
An output tax
raises the firm’s
marginal cost by the
amount of the tax.
MC1
The firm will
reduce output to
the point at which
the marginal cost
plus the tax equals
the price.
t
P1
AVC2
AVC1
q2
Chapter 8
q1
Output
Slide 52
Effect of an Output
Tax on Industry Output
Price
($ per
unit of
output)
S2 = S1 + t
S1
t
P2
Tax shifts S1 to S2 and
output falls to Q2. Price
increases to P2.
P1
D
Q2
Chapter 8
Q1
Output
Slide 53
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 54
Summary

In the short run, a competitive firm
maximizes its profit by choosing an
output at which price is equal to (shortrun) 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 55
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 profitmaximizing output.
Chapter 8
Slide 56
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.
Chapter 8
Slide 57
End of Chapter 8