Download Chapter 1

Distribution of Grades
Midterm #2
25
20
15
10
5
0
10
15
20
25
30
35
40
45
50
Mean = 28.30
Median = 29
©2005 Pearson Education, Inc.
Chapter 8
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Chapter 8
Profit Maximization and
Competitive Supply
Perfectly Competitive Markets
 The model of perfect competition can be
used to study a variety of markets
 Basic assumptions of Perfectly
Competitive Markets
1. Price taking
2. Product homogeneity
3. Free entry and exit
©2005 Pearson Education, Inc.
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When are Markets Competitive?
 Few real products are perfectly
competitive
 Many markets are, however, highly
competitive
They face relatively low entry and exit costs
Highly elastic demand curves
 No rule of thumb to determine whether a
market is close to perfectly competitive
Depends on how they behave in situations
©2005 Pearson Education, Inc.
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Profit Maximization
 Do firms maximize profits?
Managers in firms may be concerned with
other objectives
 Revenue
maximization
 Revenue growth
 Dividend maximization
 Short-run profit maximization (due to bonus or
promotion incentive)
 Could
©2005 Pearson Education, Inc.
be at expense of long run profits
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Profit Maximization
 Implications of non-profit objective
Over the long run, investors would not
support the company
Without profits, survival is unlikely in
competitive industries
 Managers have constrained freedom to
pursue goals other than long-run profit
maximization
©2005 Pearson Education, Inc.
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 We can study profit maximizing output for
any firm, whether perfectly competitive or
not
Profit () = Total Revenue - Total Cost
If q is output of the firm, then total revenue is
price of the good times quantity
Total Revenue (R) = Pq
©2005 Pearson Education, Inc.
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 Costs of production depends on output
Total Cost (C) = C(q)
 Profit for the firm, , is difference
between revenue and costs
 (q)  R(q )  C (q)
©2005 Pearson Education, Inc.
Chapter 8
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Profit Maximization – Short Run
Cost,
Revenue,
Profit
($s per
year)
Profits are maximized where MR (slope
at A) and MC (slope at B) are equal
C(q)
A
R(q)
Profits are
maximized
where R(q) –
C(q) is
maximized
B
0
q0
©2005 Pearson Education, Inc.
q*
Chapter 8
Output
(q)
9
Marginal Revenue, Marginal
Cost, and Profit Maximization
 Profit is maximized at the point at which
an additional increment to output leaves
profit unchanged
  R C
 R C


0
q q q
 MR  MC  0
MR  MC
©2005 Pearson Education, Inc.
Chapter 8
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 The Competitive Firm
Price taker – market price and output
determined from total market demand and
supply
Market output (Q) and firm output (q)
Market demand (D) and firm demand (d)
©2005 Pearson Education, Inc.
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The Competitive Firm
 Demand curve faced by an individual firm
is a horizontal line
Firm’s sales have no effect on market price
 Demand curve faced by whole market is
downward sloping
Shows amount of goods all consumers will
purchase at different prices
©2005 Pearson Education, Inc.
Chapter 8
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The Competitive Firm
Price
$ per
bushel
Firm
Price
$ per
bushel
Industry
S
$4
d
$4
D
100
©2005 Pearson Education, Inc.
200
Output
(bushels)
Chapter 8
100
Output
(millions
of bushels)
13
The Competitive Firm
 The competitive firm’s demand
Individual producer sells all units for $4
regardless of that producer’s level of output
MR = P with the horizontal demand curve
For a perfectly competitive firm, profit
maximizing output occurs when
MC (q)  MR  P  AR
©2005 Pearson Education, Inc.
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Choosing Output: Short Run
 In the short run, capital is fixed and firm
must choose levels of variable inputs to
maximize profits
 We can look at the graph of MR, MC,
ATC and AVC to determine profits
 The point where MR = MC, the profit
maximizing output is chosen
©2005 Pearson Education, Inc.
Chapter 8
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A Competitive Firm
MC
Price
Lost Profit
for q2>q*
Lost Profit
for q1 < q*
50
A
40
AR=MR=P
ATC
AVC
30
q1 : MR > MC
q2: MC > MR
q*: MC = MR
20
10
0
1
2
3
4
5
6
7
q1
©2005 Pearson Education, Inc.
Chapter 8
8
q*
9
q2
10
11
Output
16
A Competitive Firm – Positive
Profits
Price
50
40
MC
Total
Profit =
ABCD
A
D
AR=MR=P
ATC
Profit per
unit = PAC(q) = A
to B
30 C
Profits are
determined
by output per
unit times
quantity
AVC
B
20
10
0
1
2
3
4
5
6
7
q1
©2005 Pearson Education, Inc.
Chapter 8
8
q*
9
q2
10
11
Output
17
The Competitive Firm
 A firm does not have to make profits
 It is possible a firm will incur losses if the
P < AC for the profit maximizing quantity
Still measured by profit per unit times
quantity
Profit per unit is negative (P – AC < 0)
©2005 Pearson Education, Inc.
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A Competitive Firm – Losses
MC
Price
ATC
B
C
D
A
P = MR
q *:
At
MR =
MC and P <
ATC
Losses =
(P- AC) x q*
or ABCD
AVC
q*
©2005 Pearson Education, Inc.
Chapter 8
Output
19
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 P < ATC the firm is making losses
©2005 Pearson Education, Inc.
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Short Run Production
 Why would a firm produce at a loss?
Might think price will increase in near future
Shutting down and starting up could be
costly
 Firm has two choices in short run
Continue producing
Shut down temporarily
Will compare profitability of both choices
©2005 Pearson Education, Inc.
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Short Run Production
 When should the firm shut down?
If AVC < P < ATC, the firm should continue
producing in the short run
 Can
cover all of its variable costs and some of
its fixed costs
If AVC > P < ATC, the firm should shut down
 Cannot
cover its variable costs or any of its
fixed costs
©2005 Pearson Education, Inc.
Chapter 8
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A Competitive Firm – Losses
MC
Price
ATC
Losses
B
C
D
P < ATC but
AVC so
firm will
continue to
produce in
short run
A
P = MR
AVC
F
E
q*
©2005 Pearson Education, Inc.
Chapter 8
Output
23
Competitive Firm – Short Run
Supply
 Supply curve tells how much output will
be produced at different prices
 Competitive firms determine quantity to
produce where P = MC
Firm shuts down when P < AVC
 Competitive firms’ supply curve is portion
of the marginal cost curve above the AVC
curve
©2005 Pearson Education, Inc.
Chapter 8
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A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the
output level where P = MR = MC,
as long as P > AVC.
Supply is MC
above AVC
MC
S
P2
ATC
P1
AVC
P = AVC
q1
©2005 Pearson Education, Inc.
Chapter 8
q2 Output
25
The Response of a Firm to
a Change in Input Price
Price
($ per
unit)
MC2
Savings to the firm
from reducing output
Input cost increases
and MC shifts to MC2
and q falls to q2.
MC1
$5
q2
©2005 Pearson Education, Inc.
Chapter 8
q1
Output
26
Short-Run Market Supply Curve
 Shows the amount of product the whole
market will produce at given prices
 Is the sum of all the individual producers
in the market
 We can show graphically how we can
sum the supply curves of individual
producers
©2005 Pearson Education, Inc.
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Industry Supply in the Short
Run
S
The short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
$ per
unit
P3
P2
P1
Q
2
©2005 Pearson Education, Inc.
4
5
7 8
10
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21
28
Long-Run Competitive
Equilibrium
 For long run equilibrium, firms must have
no desire to enter or leave the industry
 Relate economic profit to the incentive to
enter and exit the market
 Relate accounting profit to economic
profit
©2005 Pearson Education, Inc.
Chapter 8
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Long-Run Competitive
Equilibrium
 Accounting profit
Difference between firm’s revenues and
direct costs
 Economic profit
Difference between firm’s revenues and
direct and indirect costs
Takes into account opportunity costs
©2005 Pearson Education, Inc.
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Long-Run Competitive
Equilibrium
 Firm uses labor (L) and capital (K) with
purchased capital
 Accounting Profit and Economic Profit
Accounting profit:  = R - wL
Economic profit:  = R = wL - rK
 wl
= labor cost
 rk = opportunity cost of capital
©2005 Pearson Education, Inc.
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Long-Run Competitive
Equilibrium
 Zero-Profit
A firm is earning a normal return on its
investment
Doing as well as it could by investing its
money elsewhere
Normal return is firm’s opportunity cost of
using money to buy capital instead of
investing elsewhere
Competitive market long run equilibrium
©2005 Pearson Education, Inc.
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Long-Run Competitive
Equilibrium
 Zero Economic Profits
If R > wL + rk, economic profits are positive
If R = wL + rk, zero economic profits, but the
firm is earning a normal rate of return,
indicating the industry is competitive
If R < wl + rk, consider going out of business
©2005 Pearson Education, Inc.
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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
This continues until there are no more profits
to be gained in the market – zero economic
profits
©2005 Pearson Education, Inc.
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Long-Run Competitive
Equilibrium – Profits
•Profit attracts firms
•Supply increases until profit = 0
$ per
unit of
output
$ per
unit of
output
Firm
Industry
S1
LMC
$40
LAC
P1
S2
P2
$30
D
q2
©2005 Pearson Education, Inc.
Output
Chapter 8
Q1
Q2
Output
35
Long-Run Competitive
Equilibrium – Losses
•Losses cause firms to leave
•Supply decreases until profit = 0
$ per
unit of
output
Firm
LMC
$ per
unit of
output
LAC
$30
Industry
S2
P2
S1
P1
$20
D
q2
©2005 Pearson Education, Inc.
Output
Chapter 8
Q2
Q1
Output
36
Long-Run Competitive
Equilibrium
1. All firms in industry are maximizing
profits
 MR = MC
2. No firm has incentive to enter or exit
industry
 Earning zero economic profits
3. Market is in equilibrium
 QD = Q S
©2005 Pearson Education, Inc.
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Choosing Output in the Long
Run
 Economic Rent
The difference between what firms are willing
to pay for an input less the minimum amount
necessary to obtain it
When some have accounting profits that are
larger than others, they still earn zero
economic profits because of the willingness
of other firms to use the factors of production
that are in limited supply
©2005 Pearson Education, Inc.
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Choosing Output in the Long
Run
 An Example
Two firms A & B that both own their land
A is located on a river which lowers A’s
shipping cost by $10,000 compared to B
The demand for A’s river location will
increase the price of A’s land to $10,000 =
economic rent
Although economic rent has increased,
economic profit has become zero
©2005 Pearson Education, Inc.
Chapter 8
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Firms Earn Zero Profit in
Long-Run Equilibrium
Ticket
Price
LMC
LAC
A baseball team
in a moderate-sized city
sells enough
tickets so that price
is equal to marginal
and average cost
(profit = 0).
$7
1.0
©2005 Pearson Education, Inc.
Chapter 8
Season Tickets
Sales (millions)
40
Firms Earn Zero Profit in
Long-Run Equilibrium
Ticket
Price
LMC
Economic Rent
LAC
$10
$7.20
A team with the same
cost in a larger city
sells tickets for $10.
1.3
©2005 Pearson Education, Inc.
Chapter 8
Season Tickets
Sales (millions)
41
Firms Earn Zero Profit in
Long-Run Equilibrium
 With a fixed input such as a unique
location, the difference between the cost
of production (LAC = 7) and price ($10) is
the value or opportunity cost of the input
(location) and represents the economic
rent from the input
©2005 Pearson Education, Inc.
Chapter 8
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Firms Earn Zero Profit in
Long-Run Equilibrium
 If the opportunity cost of the input (rent) is
not taken into consideration, it may
appear that economic profits exist in the
long run (positive accounting profits)
©2005 Pearson Education, Inc.
Chapter 8
43