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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
©2005 Pearson Education, Inc.
Chapter 8
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
©2005 Pearson Education, Inc.
Chapter 8
3
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.
Chapter 8
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Perfectly Competitive Markets
1. Price Taking
 The individual firm sells a very small share
of the total market output and, therefore,
cannot influence market price.
 Each firm takes market price as given –
price taker
 The individual consumer buys too small a
share of industry output to have any impact
on market price.
©2005 Pearson Education, Inc.
Chapter 8
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Perfectly Competitive Markets
2. Product Homogeneity
 The products of all firms are perfect
substitutes.
 Product quality is relatively similar as well
as other product characteristics
 Agricultural products, oil, copper, iron,
lumber
 Heterogeneous products, such as brand
names, can charge higher prices because
they are perceived as better
©2005 Pearson Education, Inc.
Chapter 8
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Perfectly Competitive Markets
3. Free Entry and Exit
 When there are no special costs that make
it difficult for a firm to enter (or exit) an
industry
 Buyers can easily switch from one supplier
to another.
 Suppliers can easily enter or exit a market.

Pharmaceutical companies not perfectly
competitive because of the large costs of R&D
required
©2005 Pearson Education, Inc.
Chapter 8
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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.
Chapter 8
8
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
Chapter 8
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Profit Maximization
 Implications of non-profit objective
Over the long-run investors would not
support the company
Without profits, survival unlikely in
competitive industries
 Managers have constrained freedom to
pursue goals other than long-run profit
maximization
©2005 Pearson Education, Inc.
Chapter 8
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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) = Cq
 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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Marginal Revenue, Marginal
Cost, and Profit Maximization
 Firm selects output to maximize the
difference between revenue and cost
 We can graph the total revenue and total
cost curves to show maximizing profits
for the firm
 Distance between revenues and costs
show profits
©2005 Pearson Education, Inc.
Chapter 8
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 Revenue is curved showing that a firm
can only sell more if it lowers its price
 Slope in revenue curve is the marginal
revenue
Change in revenue resulting from a one-unit
increase in output
 Slope of total cost curve is marginal cost
Additional cost of producing an additional
unit of output
©2005 Pearson Education, Inc.
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Marginal Revenue, Marginal
Cost, and Profit Maximization
 If the producer tries to raise price, sales are
zero.
 Profit is negative to begin with since revenue is
not large enough to cover fixed and variable
costs
 As output rises, revenue rises faster than costs
increasing profit
 Profit increases until it is maxed at q*
 Profit is maximized where MR = MC or where
slopes of the R(q) and C(q) curves are equal
©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)
16
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.
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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 good 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)
20
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
 We will combine revenue and costs with
demand to determine profit maximizing
output decisions.
 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
©2005 Pearson Education, Inc.
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Choosing Output: Short Run
 The point where MR = MC, the profit
maximizing output is chosen
MR=MC at quantity, q*, of 8
At a quantity less than 8, MR>MC so more
profit can be gained by increasing output
At a quantity greater than 8, MC>MR,
increasing output will decrease profits
©2005 Pearson Education, Inc.
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A Competitive Firm
MC
Price
Lost Profit
for q2>q*
Lost Profit
for q2>q*
50
A
40
AR=MR=P
ATC
AVC
30
q1 : MR > MC
q2: MC > MR
q0: 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
24
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
25
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
27
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
 When should the firm shut down?
If AVC < P < ATC the firm should continue
producing in the short run
 Can
cover some of its fixed costs and all of its
variable costs so the loss is small than the fixed
costs if no production
If AVC > P < ATC the firm should shut-down.
 Can
©2005 Pearson Education, Inc.
not cover even its fixed costs
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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
30
Some Cost Considerations for
Managers
 Three guidelines for estimating marginal
cost:
1. Average variable cost should not be used
as a substitute for marginal cost.
2. A single item on a firm’s accounting ledger
may have two components, only one of
which involved marginal cost
3. All opportunity costs should be included in
determining marginal cost
©2005 Pearson Education, Inc.
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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.
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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
33
A Competitive Firm’s
Short-Run Supply Curve
 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.
©2005 Pearson Education, Inc.
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A Competitive Firm’s
Short-Run Supply Curve
 Over time prices of product and inputs
can change
 How does the firm’s output change in
response to a change in the price of an
input.
We can show an increase in marginal costs
and the change in the firms output decisions
©2005 Pearson Education, Inc.
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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
36
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
Chapter 8
15
21
38
The Short-Run Market Supply
Curve
 As price rises, firms expand their production
 Increased production leads to increased
demand for inputs and could cause increases in
input prices
 Increases in input prices cause MC curve to rise
 This lowers each firm’s output choice
 Causes industry supply to be less responsive to
change in price than would be otherwise
©2005 Pearson Education, Inc.
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Elasticity of Market Supply
 Elasticity of Market Supply
Measures the sensitivity of industry output to
market price
The percentage change in quantity supplied,
Q, in response to 1-percent change in price
Es  (Q / Q) /( P / P)
©2005 Pearson Education, Inc.
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Elasticity of Market Supply
 When MC increase rapidly in response to
increases in output, elasticity is low
 When MC increase slowly, supply is relatively
elastic
 Perfectly inelastic short-run supply arises when
the industry’s plant and equipment are so fully
utilized that new plants must be built to achieve
greater output.
 Perfectly elastic short-run supply arises when
marginal costs are constant.
©2005 Pearson Education, Inc.
Chapter 8
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Producer Surplus in the Short
Run
 Price is greater than MC on all but the
last unit of output.
 Therefore, surplus is earned on all but
the last unit
 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.
 Area above supply to the market price
©2005 Pearson Education, Inc.
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Producer Surplus for a Firm
Price
($ per
unit of
output)
MC
Producer
Surplus
AVC
B
A
P
At q* MC = MR.
Between 0 and q ,
MR > MC for all units.
Producer surplus
is area above MC
to the price
q*
©2005 Pearson Education, Inc.
Chapter 8
Output
43
The Short-Run Market Supply
Curve
 Sum of MC from 0 to q*, it is the sum o
the total variable cost of producing q*
 Producer Surplus can be defined as
difference between the firm’s revenue
and it total variable cost
 We can show this graphically by the
rectangle ABCD
Revenue (0ABq*) minus variable cost
(0DCq*)
©2005 Pearson Education, Inc.
Chapter 8
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Producer Surplus for a Firm
Price
($ per
unit of
output)
MC
Producer
Surplus
AVC
B
A
D
P
C
q*
©2005 Pearson Education, Inc.
Chapter 8
Producer surplus
is also ABCD =
Revenue minus
variable costs
Output
45
Producer Surplus versus Profit
 Profit is revenue minus total cost (not just
variable cost)
 When fixed cost is positive, producer
surplus is greater than profit
Producer Surplus  PS  R - VC
Profit   - R - VC - FC
©2005 Pearson Education, Inc.
Chapter 8
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Producer Surplus versus Profit
 Costs of production determine magnitude
of producer surplus
Higher costs firms have less producer
surplus
Lower cost firms have more producer surplus
Adding up surplus for all producers in the
market given total market producer surplus
Area below market price and above supply
curve
©2005 Pearson Education, Inc.
Chapter 8
47
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*
©2005 Pearson Education, Inc.
Chapter 8
Output
48
Choosing Output in the Long
Run
 In short run, one or more inputs are fixed
Depending on the time, it may limit the
flexibility of the firm
 In the long run, a firm can alter all its
inputs, including the size of the plant.
 We assume free entry and free exit.
No legal restrictions or extra costs
©2005 Pearson Education, Inc.
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49
Choosing Output in the Long
Run
 In the short run a firm faces a horizontal
demand curve
 Take market price as given
 The short-run average cost curve (SAC) and
short run marginal cost curve (SMC) are low
enough for firm to make positive profits (ABCD)
 The long run average cost curve (LRAC)
 Economies of scale to q2
 Diseconomies of scale after q2
©2005 Pearson Education, Inc.
Chapter 8
50
Output Choice in the Long Run
Price
LMC
LAC
SMC
SAC
$40
D
A
P = MR
C
B
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1
©2005 Pearson Education, Inc.
Chapter 8
q2
q3
Output
51
Output Choice in the Long Run
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
Price
LMC
LAC
SMC
SAC
$40
D
A
P = MR
C
B
G
$30
F
q1
©2005 Pearson Education, Inc.
Chapter 8
q2
q3
Output
52
Long-Run Competitive
Equilibrium
 For long run equilibrium, firms must have
no desire to enter or leave the industry
 We can relate economic profit to the
incentive to enter and exit the market
 Need to relate accounting profit to
economic profit
©2005 Pearson Education, Inc.
Chapter 8
53
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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54
Long-run Competitive
Equilibrium
 Firm uses labor (L) and capital (K) with
purchased capital
 Accounting Profit & Economic Profit
Accounting profit:  = R - wL
Economic profit:  = R = wL - rK
 wl
= labor cost
 rk = opportunity cost of capital
©2005 Pearson Education, Inc.
Chapter 8
55
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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56
Long-run Competitive
Equilibrium
 Zero Economic Profits
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
©2005 Pearson Education, Inc.
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57
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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58
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
59
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
60
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 = QD
©2005 Pearson Education, Inc.
Chapter 8
61
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 are
larger than others, 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.
Chapter 8
62
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
63
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)
64
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)
65
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
66
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.
©2005 Pearson Education, Inc.
Chapter 8
67
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 of
inputs.
©2005 Pearson Education, Inc.
Chapter 8
68
The Industry’s Long-Run Supply
Curve
 Assume
All firms have access to the available
production technology
Output is increased by using more inputs,
not by invention
The market for inputs does not change with
expansions and contractions of the industry.
©2005 Pearson Education, Inc.
Chapter 8
69
The Industry’s Long-Run Supply
Curve
 To analyze long-run industry supply, will
need to distinguish between three
different types of industries
1. Constant-Cost
2. Increasing-Cost
3. Decreasing-Cost
©2005 Pearson Education, Inc.
Chapter 8
70
Constant-Cost Industry
 Industry whose long-run supply curve is
horizontal
 Assume a firm is initially in equilibrium
Demand increases causing price to increase
Individual firms increase supply
Causes firms to earn positive profits in shortrun
Supply increases causing market price to
decrease
Long run equilibrium – zero economic profits
©2005 Pearson Education, Inc.
Chapter 8
71
Constant-Cost Industry
$
Increase in demand increases
market price and firm output
Positive profits cause market
supply to increase and price to fall
MC
$
Q1 increases to Q2.
Long-run supply = SL = LRAC.
Change in output has no impact on
input cost.
S1
AC
P2
P2
P1
P1
S2
SL
D1
q1 q2
©2005 Pearson Education, Inc.
Output
Chapter 8
Q1
Q2
D2
Output
72
Long-Run Supply in a
Constant-Cost Industry
 Price of inputs does not change
Firms cost curves do not change
 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.
©2005 Pearson Education, Inc.
Chapter 8
73
Increasing-Cost Industry
 Prices of some or all inputs rises as
production is expanded when demand of
inputs increases
 When demand increases causing prices
to increase and production to increase
Firms enter the market increasing demand
for inputs
Costs increase causing an upward shift in
supply curves
Market supply increases but not as much
©2005 Pearson Education, Inc.
Chapter 8
74
Long-run Supply in an
Increasing-Cost Industry
Due to the increase in input prices, longrun equilibrium occurs at a higher price.
SMC2
$
$
SMC1
S1 S2
LAC2
LAC1
P2
Long Run Supply is
upward Sloping
P2
P3
P3
P1
P1
D1
q1
©2005 Pearson Education, Inc.
q2
Output
Chapter 8
SL
Q1 Q2 Q3
D2
Output
75
Long-Run Supply in a
Increasing-Cost Industry
 In a increasing-cost industry, long-run
supply curve is upward sloping.
 More output is produced, but only at the
higher price needed to compete for the
increased input costs
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Decreasing-Cost Industry
 Industry whose long-run supply curve is
downward sloping
 Increase in demand causes production to
increase
Increase in size allows firm to take
advantage of size to get inputs cheaper
Increased production may lead to better
efficiencies or quantity discounts
Costs shift down and market price falls
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Long-run Supply in a
Decreasing-Cost Industry
$
Due to the decrease
in input prices, long-run
equilibrium occurs at
a lower price.
SMC1
Long Run Supply is Downward
Sloping
$
S1
S2
SMCLAC
2
1
LAC2 P2
P2
P1
P1
P3
P3
SL
D1
q1 q2
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Output
Chapter 8
Q1 Q2 Q3
D2
Output
78
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.
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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
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q1
Output
80
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
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Q1
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Output
81
Long-Run Elasticity of Supply
1. Constant-cost industry
 Long-run supply is horizontal
 Small increase in price will induce an
extremely large output increase
 Long-run supply elasticity is infinitely large
 Inputs would be readily available
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Long-Run Elasticity of Supply
2. Increasing-cost industry
 Long-run supply is upward-sloping and
elasticity is positive
 The slope (elasticity) will depend on the rate
of increase in input cost
 Long-run elasticity will generally be greater
than short-run elasticity of supply
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