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Chapter 7
Profit Maximization and
Competitive Market
Model of Perfectly Competitive
Market
• The model of perfect competition rests on
three basic assumptions:
1. Price taking.
2. Product homogeneity.
3. Free entry and exit.
Price Taking
• Many firms compete in the market.
• Firm faces a significant number of direct competitors
for its products.
• Each individual firm sells a sufficiently small proportion
of total market output, its decisions have no impact on
market price.
• A price taking consumer is a consumer whose actions
have no effect on the market price of the good or
service s/he buys.
• A price taking producer is a producer whose actions
have no effect on the market price of the good or
service it sells.
Product homogeneity
• When the products of al of the firms in a market are
perfectly substitutable with one another.
• when products are homogeneous, no firm can raise the
price of its product above the price of other firms
without losing most or all of its business.
• Example: Most agricultural products are homogeneous: Because product
quality is relatively similar among farms in a given region.
• In contrast, when products are heterogeneous, each firm
has the opportunity to raise its price above that of its
competitors without losing all of its sales.
• Example: Premium ice creams such as Haagen-Dazs, for example, can be
sold at higher prices because Haagen-Dazs has different ingredients and is
perceived by many consumers to be a higher-quality product.
Free entry and exit
• We say there is free entry and exit into and from an industry when
new producers can easily enter into and leave an industry.
• Thus it is easy to for a buyer to switch from one supplier to another.
• There should be no obstacles in the form of government regulations
or limited access to key resources to prevent new producers from
entering the market.
• There must also be no additional costs associated with shutting
down and leaving an industry.
• Example: The pharmaceutical industry, is not perfectly competitive because
Merck, Pfizer, and few other firms hold patents that give them unique
rights to produce drugs. Any new entrant would either have to invest in
research and development to obtain its own competing drugs or pay
substantial license fees to one or more firms already in the market. R&D
expenditures or license fees could limit a firm’s ability to enter the market.
Marginal Revenue (MR) & Marginal
Cost (MC)
• the additional revenue resulting from the sale
of an additional unit of output is called
marginal revenue (MR)
• MR = TR/q
• the additional cost resulting from the sale of
an additional unit of output is called marginal
cost (MC)
• MC = TC/q
MR > MC
• If marginal revenue exceeds marginal cost, the
production of an additional unit of output
adds more to revenue than to costs.
• In this case, a firm is expected to increase its
level of production to increase its profits.
MR < MC
• If marginal cost exceeds marginal revenue, the
production of the last unit of output costs
more than the additional revenue generated
by the sale of this unit.
• In this case, firms can increase their profits by
producing less.
• A profit-maximizing firm will produce more
output when MR > MC and less output when
MR < MC.
MR = MC
• If MR = MC, however, the firm has no
incentive to produce either more or less
output.
• The firm's profits are maximized at the level
of output at which MR = MC.
Goal of Profit Maximization
• To analyze decision making at the firm, let’s
start with a very basic question
– What is the firm trying to maximize?
• A firm’s owners will usually want the firm to
earn as much profit $ as possible
• We will view the firm as a single economic
decision maker whose goal is to maximize its
owners’ or stakeholders’ profit.
Profit Maximization
Profit is defined as the firm’s sales revenue
minus its costs of production
Profit = Total Revenue – Total Cost
Profit = (profit per unit) x # of units
= (P – ATC) x Q
Total Revenue
• The total inflow of receipts from selling a given amount
of output
• Each time the firm chooses a level of output, it also
determines its total revenue
– Why?
• Because once we know the level of output, we also know the
highest price the firm can charge
• Total revenue—which is the number of units of output
times the price per unit—
• Total Revenue(TR)= Price(P) x Quantity(Q)
• Average Revenue is how much revenue a firm is getting
by producing one item.
• Average Revenue(AR) = Total Revenue(TR) / Quantity(Q)
Profit Maximization in a Competitive
Market
• Since in a competitive market there is price taking
meaning that no matter how much a firm produces,
there will be no impact on the Price as far as Quantity
produced or demanded.
• Therefore P= MR = MC
• Example: when a farmer is deciding how many acres of wheat to plant in a
given year, he can take the market price of wheat let’s say, $4 per bushel
as a given price. That price will not be affected by his acreage decision.
• We then have a horizontal demand curve, it can sell an additional unit of
output without lowering the price. As a result, when it sells an additional
unit, the firm’s total revenue increases by an amount equal to the price:
one bushel of wheat sold for $4 yields additional revenue of $4. Thus
marginal revenue is constant at $4.
Problem 1
Problem 1
• Questions:
• Find the MR and MC?
• At which quantity we have profit
maximization?
Problem 2
• Calculate the TR and Profit for the following firm
• What quantity of production maximizes profit?
Q
P
TC
0
-
4
1
18
6
2
15
10
3
12
16
4
9
24
5
6
34
6
3
46
Solution to Problem 2
Q
P
TC
TR
Profit
MR
MC
0
-
4
0
-4
-
-
1
18
6
18
12
18
2
2
15
10
30
20
12
4
3
12
16
36
20
6
6
4
9
24
36
12
0
8
5
6
34
30
-4
-6
10
6
3
46
18
-28
-12
12
Problem 3
• Assuming the market price of a good is $8 and
the firm’s total cost TC= 40 + 0.5Q + 0.05Q2
• What is the ideal quantity to be produced to
maximize profit?
• What is the firms Profit at the ideal quantity?
Solution to Problem 3
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In Perfectly competitive market:
P = MC
MC= d(TC)/d(Q)=0.5 + 0.1Q
MC= 0.5 + 0.1Q
P= 0.5 +0.1 Q
8= 0.5 +0.1Q
0.1Q= 7.5  Q = 75
TR= 8*75 = $600
TC= 40+0.5(75)+ 0.5 (75*75) = $358.75
Profit= TR – TC = 600 – 358.75 = $241.25
Problem 4
• In a perfect competitive market we have the
following curves for demand and supply.
• Qd= 100 – 10P
• Qs= 50P – 200
• The firm’s marginal cost is MC = 4 + Q
• How much output does this firm has to
produce in order to maximize its profit?
Solution to Problem 4
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First we find the equilibrium price:
100 – 10P = 50P – 200
60P = 300
P = $5
In a competitive market P=MC
5= 4 + Q
Q=1