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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 Short-run profit 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 Profit Maximization in the Short Run Total Revenue Cost, Revenue, Profit ($s per year) R(q) Slope of R(q) = MR 0 Output (units per year) Chapter 8 Slide 11 Profit Maximization in the Short Run C(q) Cost, Revenue, Profit $ (per year) Total Cost Slope of C(q) = MC Why is cost positive when q is zero? 0 Output (units per year) Chapter 8 Slide 12 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 13 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 14 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 15 Marginal Revenue, Marginal Cost, and Profit Maximization Comparing R(q) and C(q) Output level: q* R(q)= C(q) MR = MC Profit is maximized Cost, Revenue, Profit $ (per year) C(q) R(q) A B 0 q0 q* (q) Output (units per year) Chapter 8 Slide 16 Marginal Revenue, Marginal Cost, and Profit Maximization Question Why is profit reduced when producing more or less than q*? Cost, Revenue, Profit $ (per year) C(q) R(q) A B 0 q0 q* (q) Output (units per year) Chapter 8 Slide 17 Marginal Revenue, Marginal Cost, and Profit Maximization Comparing R(q) and C(q) Output levels beyond q*: R(q)> C(q) Cost, Revenue, Profit $ (per year) C(q) R(q) A MC > MR Profit is decreasing B 0 q0 q* (q) Output (units per year) Chapter 8 Slide 18 Marginal Revenue, Marginal Cost, and Profit Maximization Therefore, it can be said: Cost, Revenue, Profit $ (per year) C(q) Profits are maximized when MC = MR. R(q) A B 0 q0 q* (q) Output (units per year) Chapter 8 Slide 19 Marginal Revenue, Marginal Cost, and Profit Maximization R-C R MR q C MC q Chapter 8 Slide 20 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 21 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 22 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 Individual producer sells all units for $4 regardless of the producer’s level of output. If the producer tries to raise price, sales are zero. P Chapter 8 competitive firm’s demand = D = MR = AR Slide 24 Marginal Revenue, Marginal Cost, and Profit Maximization The Competitive Firm Profit Chapter 8 Maximization MC(q) = MR = P Slide 25 A Competitive Firm Making a Positive Profit MC Price 60 ($ per unit) 50 40 Lost profit for q q < 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 q0: MC = MR but MC falling 10 0 (P - AC) 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 26 A Competitive Firm Incurring Losses MC Price ($ per unit) C D At q*: MR = MC and P < ATC Losses = P- AC) 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 27 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 should produce at a loss. If P < AVC < ATC the firm should shutdown. Chapter 8 Slide 28 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 29 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 30 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 31 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 32 A Competitive Firm’s Short-Run Supply Curve Firm’s Response to an Input Price Change When the price of a firm’s product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. How does the firm's output decision change in response to a change in the prices of one of the firm's inputs? Chapter 8 Slide 33 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 34 The Short-Run Market Supply Curve The short-run market supply curve shows the amount of output that the industry will produce in the short-run for every possible price. Consider, for simplicity, a competitive market with three firms: Chapter 8 Slide 35 Industry Supply in the Short Run MC1 $ per unit MC2 MC3 The short-run industry supply curve is the horizontal summation of the supply curves of the firms. P3 P2 P1 0 Chapter 8 Question: If increasing output raises input costs, what impact would it have on market supply? 2 4 5 7 8 10 15 Quantity 21 Slide 36 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 37 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 38 The Short-Run Market Supply Curve Producer Surplus in the Short-Run Producer Surplus PS R - VC Profit - R - VC - FC Short-run with positive fixed cost PS Chapter 8 Slide 39 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 40 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 41 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 = $40 > ATC. Profit is equal to ABCD. q1 Chapter 8 q2 q3 Output Slide 42 Output Choice in the Long Run Price ($ per unit of output) Question: Is the producer making a profit after increased output lowers the price to $30? LMC LAC SMC D SAC A E $40 C G P = MR B F $30 q1 Chapter 8 q2 q3 Output Slide 43 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 and profits. Profits will attract other producers. More producers increase industry supply which lowers the market price. Chapter 8 Slide 44 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 46 The Industry’s Long-Run Supply Curve The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices the firms must pay for inputs. Chapter 8 Slide 47 Long-Run Supply in a Constant-Cost Industry In a constant-cost industry, long-run supply is a horizontal line at a price that is equal to the minimum average cost of production. Chapter 8 Slide 48 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 Increasing-Cost Industry In a increasing-cost industry, long-run supply curve is upward sloping. Chapter 8 Slide 50 Long-Run Supply in an Increasing-Cost Industry $ per unit of output SMC2 LAC2 $ per unit of output Due to the increase in input prices, long-run equilibrium occurs at a higher price. S1 S2 LAC1 P2 P2 P3 P3 P1 P1 B A D1 q1 SL SMC1 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 52 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 SMC1 SMC2 LAC1 P2 P2 LAC2 P1 P1 P3 P3 A B SL D1 q1 q2 Output Q1 Q2 Q3 D2 Output The Industry’s Long-Run Supply Curve The Effects of a Tax Chapter 8 Now, we will consider how a firm responds to a tax on its output. Slide 54 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 55 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 56 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 57 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 58 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 59 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 60 End of Chapter 8 Profit Maximization and Competitive Supply