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PROFIT MAXIMISATION BY A FIRM IN A COMPETITIVE MARKET MAIN TOPICS • DEFINITION OF A COMPETITIVE MARKET • MARKET DEMAND AND FIRM DEMAND • TOTAL REVENUE OF THE FIRM • MARGINAL REVENUE OF THE FIRM • TOTAL REVENUE LESS TOTAL COSTS • MARGINAL COST AND PROFIT MAXIMISATION COMPETITIVE MARKETS • Large number of buyers: None can control the price • Large number of sellers: None can control the price • Uniform commodity: All sellers are selling identical commodities, so they are perfect substitutes • Entry to the industry is easy. • Established firms do not have an advantage over new firms MARKET DEMAND QUANTITY PRICE 0 40 10 35 20 30 30 25 40 20 50 15 60 10 70 5 80 0 MARKET DEMAND AND SUPPLY MARKET SUPPLY AND DEMAND PRICE 45 40 35 30 25 20 15 10 5 0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 QUANTITY DEMAND FOR ONE FIRM’S OUTPUT • The firm is a small part of the market • Other firm’s products are perfect substitutes • The firm can charge no more than the market price A FIRM’S DEMAND SCHEDULE QUANTITY PRICE 0 20 10 20 20 20 30 20 40 20 50 20 60 20 70 20 80 20 A FIRM’S DEMAND CURVE FIRM'S DEMAND 40 PRICE 30 20 10 0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 QUANTITY TOTAL REVENUE OF A FIRM • The quantity a firm sells multiplied by the price of the product. TOTAL REVENUE OF A FIRM45 40 Q P 0 10 20 30 40 50 60 70 80 35 TR 20 20 20 20 20 20 20 20 20 0 200 400 600 800 1000 1200 1400 1600 30 25 20 15 10 5 0 0 5 10 1 TOTAL REVENUE OF A FIRM A FIRM'S TOTAL REVENUE REVENUE 1800 1600 1400 1200 1000 800 600 400 200 0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 QUANTITY MARGINAL REVENUE • The change in total revenue given the change in quantity • In a competitive industry marginal revenue always equals price. • That is, the firm adds the price of one more unit to its total revenue whenever it sells one more unit. • This is not true for firms in industries that are not competitive. A FIRM’S MARGINAL REVENUE SCHEDULE QUANTITY PRICE 0 10 20 30 40 50 60 70 80 TR 20 20 20 20 20 20 20 20 20 MR 0 200 400 600 800 1000 1200 1400 1600 20 20 20 20 20 20 20 20 A FIRM’S MARGINAL REVENUE CURVE FIRM'S MARGINAL REVENUE PRICE 40 35 30 25 20 15 10 5 0 0 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 QUANTITY COMPETITIVE FIRM’S PROFIT MAXIMISING DECISION • The firm is a price taker, so it cannot decide what price to charge. • Assume that the firm is producing each output at the minimum possible cost. • The firm can only decide how much to produce • The firm’s goal is to maximise profits PROFITS OF A COMPETITIVE FIRM Q TR 0 10 20 30 40 50 60 70 80 TC 0 200 400 600 800 1000 1200 1400 1600 100 150 250 400 600 900 1300 1800 2400 profits -100 50 150 200 200 100 -100 -400 -800 TOTAL REVENUE AND COST CURVES COSTS AND REVENUES TOTAL COSTS AND REVENUES OF A FIRM 1600 1400 1200 1000 800 600 400 200 0 TR TC 0 10 20 30 40 50 60 70 80 90 QUANTITY PROFITS PROFITS OFA FIRM COSTS AND REVENUES 250 200 150 100 50 0 -50 0 10 20 30 40 50 -100 -150 -200 QUANTITY 60 70 80 90 PROFIT MAXIMISATION • Profit is maximised when the difference between the total revenues and total costs is greatest • At outputs where revenues increase by more than costs if output increases, output is too low. Increasing output will increase profit. • At outputs where revenues increase by less than costs if output increases, output is too high. Decreasing output will decrease profit PROFIT MAXIMISATION • If marginal revenue equals marginal cost, then profit is maximised. • The increase in revenue equals the increase in cost when one more unit is produced. • The decrease in revenue equals the decrease in costs when one less unit is produced • Maximum profits may occur when average costs are not at a minimum. PROFIT MAXIMISATION Q MR 0 10 20 30 40 50 60 70 80 MC 20 20 20 20 20 20 20 20 20 AVC 5 10 15 20 30 40 50 60 5.00 7.50 10.00 12.50 16.00 20.00 24.29 28.75 ATC 15.00 12.50 13.33 15.00 18.00 21.67 25.71 30.00 profits -100 50 150 200 200 100 -100 -400 -800 PROFIT MAXIMISATION PROFIT MAXIMISATION 70 DOLLARS 60 50 MR 40 30 MC 20 ATC AVC 10 0 0 50 QUANTITY 100