Download Increasing-cost industry

MICROECONOMICS: Theory & Applications
Chapter 9: Profit Maximization in Perfectly
Competitive Markets
By
Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
11th Edition, Copyright 2012
PowerPoint prepared by Della L. Sue, Marist College
Assumptions of Perfect Competition
Large numbers of buyers and sellers
 Free entry and exit
 Homogeneous products
 Perfect information

Copyright 2012
John Wiley & Sons, Inc.
2
Profit Maximization

ASSUMPTION: firms select an output level so
as to maximize profit, defined as the
difference between revenue and cost
 “Survivor Principle” – the observation that in
competitive markets, firms that do not
approximate profit-maximizing behavior fail,
and that survivors are those firms that,
intentionally or not, make the appropriate
profit-maximizing decisions.
Copyright 2012
John Wiley & Sons, Inc.
3
The Demand Curve for a
Competitive Firm
Price taker – a firm that takes prices as given
and does not expect its output decisions to
affect price
=>horizontal demand curve
 Total revenue – price times the quantity sold
 Average revenue (AR) – total revenue divided
by output
 Marginal revenue (MR) – the change in total
revenue when there is a one-unit change in
output

Copyright 2012
John Wiley & Sons, Inc.
4
Figure 9.1 - The Competitive Firm’s
Demand Curve
Copyright 2012
John Wiley & Sons, Inc.
5
Table 9.1
Copyright 2012
John Wiley & Sons, Inc.
6
Short-Run Profit Maximization

Total profit (π) – the difference between total revenue
and total cost

TR rises in proportion to output since the price is
constant.
TC rises slowly at first and then more rapidly as the
plant facility becomes more fully utilized and MC rises.
Total profit tends to increase and then decrease as
more is produced.


Copyright 2012
John Wiley & Sons, Inc.
7
Figure 9.2 - Short-Run Profit Maximization:
Total Curves
Copyright 2012
John Wiley & Sons, Inc.
8
Short-Run Profit Maximization
Using Per-unit Curves

Average profit per unit (π/q) – total profit divided
by number of units sold

Profit is maximized at the output level where
MR=MC.


Copyright 2012
If MR>MC, profits would increase if output were
increased.
If MR<MC, profits would increase if output were
decreased.
John Wiley & Sons, Inc.
9
Figure 9.3 - Short-Run Profit Maximization
Using Per-unit Curves
Copyright 2012
John Wiley & Sons, Inc.
10
Operating at a Loss in the Short-Run

If ATC<AR at the output-level where MC=MR
=> profit is negative

Two choices:
 Temporarily shut-down
 Permanently go-out-of-business

Question: Which choice will yield smaller loss?
Copyright 2012
John Wiley & Sons, Inc.
11
Figure 9.4 - Operating at a Loss
in the Short-Run
Copyright 2012
John Wiley & Sons, Inc.
12
The Perfectly Competitive Firm’s
Short-Run Supply Curve

Short-run firm supply curve – a graph of the systematic
relationship between a product’s price and a firm’s most
profitable output level
Supply curve = MC curve where MC > minimum
point on AVC curve

Identifies most profitable output for each possible price

Shutdown point – the minimum level of average variable cost
below which the firm will cease operations
Copyright 2012
John Wiley & Sons, Inc.
13
Figure 9.5 - The Perfectly Competitive Firm’s
Short-Run Supply Curve
Copyright 2012
John Wiley & Sons, Inc.
14
Output Response to a Change in Input Prices
Question: What is the impact of a change in
input price, holding product price constant?
1) MC will shift
2) Firm will adjust output until MC=MR
Copyright 2012
John Wiley & Sons, Inc.
15
Figure 9.6 - Output Response to a
Change in Input Prices
Copyright 2012
John Wiley & Sons, Inc.
16
The Short-Run Industry Supply Curve

Short-run industry supply curve – add the quantities produced
by each firm by summing the individual firms’ marginal cost
curves horizontally

Assumption – variable input prices remain constant at all
levels of industry output

Curve slopes upward due to law of diminishing marginal
returns

Market price and output: determined by interaction between
short-run industry supply curve and the market demand curve
Copyright 2012
John Wiley & Sons, Inc.
17
Figure 9.7 - The Short-Run Competitive
Industry Supply Curve
Copyright 2012
John Wiley & Sons, Inc.
18
Long-Run Competitive Equilibrium

Allow enough time for all inputs to vary

Long-run cost curves include the opportunity cost of inputs

Zero economic profit – the point at which total profit is zero
since price equals the average cost of production; “normal”
economic return

No incentive for firms to enter or leave the industry
Copyright 2012
John Wiley & Sons, Inc.
19
Figure 9.8 - Long-Run Profit Maximization
Copyright 2012
John Wiley & Sons, Inc.
20
Long-Run Competitive Equilibrium II

Characteristics:



The firm is maximizing profit and producing
where LMC=price.
There is no incentive for firms to enter or
leave the industry.
The combined quantity of output of all the
firms at the prevailing wage equals the total
quantity consumers wish to purchase at that
price.
Copyright 2012
John Wiley & Sons, Inc.
21
Figure 9.9 – Long-Run Competitive Equilibrium
Copyright 2012
John Wiley & Sons, Inc.
22
Zero Profit When Firms’ Cost Curves Differ?

When all firms in a competitive industry have
identical cost curves, each firm earns zero
economic profit in long-run equilibrium.

What happens if cost curves differ among firms?
There is a tendency for factor inputs to receive
compensation equal to their opportunity costs.
This process leads to the zero-profit equilibrium.
Copyright 2012
John Wiley & Sons, Inc.
23
The Long-Run Industry Supply Curve

The long-run relationship between price and
industry output

depends on whether input prices are
constant, increasing, or decreasing as the
industry expands or contracts
Copyright 2012
John Wiley & Sons, Inc.
24
The Long-Run Industry Supply Curve
[Three Classifications]

Constant-cost industry: an industry in which
 expansion of output does not bid up input prices
 long-run average production cost per unit remains
unchanged, and
 the long-run industry supply curve is horizontal

Increasing-cost industry: an industry in which
 expansion of output leads to higher long-run average
production costs
 the long-run industry supply curve slopes upward

Decreasing-cost industry: an industry in which
 the long-run industry supply curve slopes downward
Copyright 2012
John Wiley & Sons, Inc.
25
Figure 9.10 – Long-Run Supply
in a Constant-Cost Industry
Copyright 2012
John Wiley & Sons, Inc.
26
Figure 9.11 – Long-Run Supply in an
Increasing-Cost Industry
Copyright 2012
John Wiley & Sons, Inc.
27
Figure 9.12 – Long-Run Supply in an
Decreasing-Cost Industry
Copyright 2012
John Wiley & Sons, Inc.
28
Comments on the Long-Run
Supply Curve

The long-run supply curve is not derived by
summing the long-run marginal cost curves of an
industry’s firms.

A movement along the long-run industry supply
curve is accompanied with the assumptions that
conditions of supply remain constant, such as:
 Technology
 conditions of input supply factors
 government regulations
 weather conditions
(continued)
Copyright 2012
John Wiley & Sons, Inc.
29
Comments on the Long-Run
Supply Curve
(continued)

Although the industry may never attain a long-run
equilibrium in reality, what is important is that there
is a tendency for the industry to move in the
direction indicated by the theory.

Economic profit is zero along a competitive
industry’s long-run supply curve.

In reality, the process of adjustment from a shortrun equilibrium to a long-run equilibrium may vary
from the theoretical description.
Copyright 2012
John Wiley & Sons, Inc.
30
When Does the Competitive Model Apply?

The assumptions of perfect competition are
stringent and are likely to be satisfied fully in very
few real-world markets.

However, many market come close enough to
satisfying the assumptions of perfect competition to
make the model useful.

And it is useful to assess the effect of deviations
from the assumptions in a real-world market.
Copyright 2012
John Wiley & Sons, Inc.
31
Copyright © 2012 John Wiley & Sons, Inc. All
rights reserved. Reproduction or translation of this
work beyond that permitted in section 117 of the
1976 United States Copyright Act without express
permission of the copyright owner is unlawful.
Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make
back-up copies for his/her own use only and not
for distribution or resale. The Publisher assumes
no responsibility for errors, omissions, or
damages caused by the use of these programs or
from the use of the information herein.
Copyright 2012
John Wiley & Sons, Inc.
32