chapter 8

Chapter 8Profit Maximization

and Competitive Supply

Profit Maximization and Competitive

Supply

Chapter 8 Slide 2

Topics to be Discussed

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

Choosing Output in the Short-Run

Chapter 8 Slide 3

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

Chapter 8 Slide 4


Characteristics of Perfectly Competitive Markets

1) Price taking

2) Product homogeneity

3) Free entry and exit

Chapter 8 Slide 5


Price Taking

The individual firm sells a very small share of the total market output and, therefore, cannot influence market price.

The individual consumer buys too small a share of industry output to have any impact on market price.

Chapter 8 Slide 6


Product Homogeneity

The products of all firms are perfect substitutes.

Examples

Agricultural products, oil, copper, iron, lumber

Chapter 8 Slide 7


Free Entry and Exit

Buyers can easily switch from one supplier to another.

Suppliers can easily enter or exit a market.

Chapter 8 Slide 8

Profit Maximization

Do firms maximize profits?

Possibility of other objectivesRevenue maximizationDividend maximizationShort-run profit maximization

Chapter 8 Slide 9

Profit Maximization

Do firms maximize profits?

Implications of non-profit objectiveOver the long-run investors would not

support the companyWithout profits, survival unlikely

Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior.

Chapter 8 Slide 10

Marginal Revenue, Marginal Cost,and Profit Maximization

Determining the profit maximizing level of outputProfit ( ) = Total Revenue - Total Cost

Total Revenue (R) = Pq

Total Cost (C) = Cq

Therefore:

)()()( qCqRq

Chapter 8 Slide 11

Profit Maximization in the Short Run

0

Cost,Revenue,

Profit($s per year)

Output (units per year)

R(q)Total Revenue

Slope of R(q) = MR

Chapter 8 Slide 12

0

Cost,Revenue,

Profit$ (per year)


Profit Maximization in the Short Run

C(q)

Total Cost

Slope of C(q) = MC

Why is cost positive when q is zero?

Chapter 8 Slide 13

Marginal revenue is the additional revenue from producing one more unit of output.

Marginal cost is the additional cost from producing one more unit of output.


Chapter 8 Slide 14

Comparing R(q) and C(q)

Output levels: 0- q0:

C(q)> R(q) Negative profit

FC + VC > R(q) MR > MC

Indicates higher profit at higher output 0

Cost,Revenue,

Profit($s per year)


R(q)

C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 15


Output levels: q0 - q*

R(q)> C(q) MR > MC

Indicates higher profit at higher output

Profit is increasing

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 16


Output level: q*

R(q)= C(q) MR = MC Profit is maximized

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 17

Question

Why is profit reduced when producing more or less than q*?

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 18


Output levels beyond q*: R(q)> C(q) MC > MR Profit is decreasing


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 19

Therefore, it can be said:

Profits are maximized when MC = MR.


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 20

C - R


q

R MR

q

CMC

Chapter 8 Slide 21

orq

C

q

R 0

q

: whenmaximized are Profits

MC(q)MR(q)

MCMR

thatso0


Chapter 8 Slide 22

The Competitive Firm

Price taker

Market output (Q) and firm output (q)

Market demand (D) and firm demand (d)

R(q) is a straight line


Demand and Marginal Revenue Facedby a Competitive Firm

Output (bushels)

Price$ per bushel

Price$ per bushel

Output (millions of bushels)

d$4

100 200 100

Firm Industry

D

$4

Chapter 8 Slide 24


The competitive firm’s demand Individual producer sells all units for $4

regardless of the producer’s level of output.

If the producer tries to raise price, sales are zero.

P = D = MR = AR


Chapter 8 Slide 25


Profit MaximizationMC(q) = MR = P


Chapter 8 Slide 26

q0

Lost profit forqq < q*

Lost profit forq2 > q*

q1 q2

A Competitive FirmMaking a Positive Profit

10

20

30

40

Price($ per

unit)

0 1 2 3 4 5 6 7 8 9 10 11

50

60MC

AVC

ATCAR=MR=P

Outputq*

At q*: MR = MCand P > ATC

ABCDor

qx AC) -(P *

D A

BC

q1 : MR > MC andq2: MC > MR andq0: MC = MR but

MC falling

Chapter 8 Slide 27

Would this producercontinue to produce with a loss?

A Competitive FirmIncurring Losses

Price($ per

unit)

Output

AVC

ATCMC

q*

P = MR

B

F

C

A

E

DAt q*: MR = MCand P < ATCLosses = P- AC) x q* or ABCD

Chapter 8 Slide 28

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 AVC < P < ATC the firm should produce at a loss.

If P < AVC < ATC the firm should shut-down.

Chapter 8 Slide 29

Observations:P = MRMR = MCP = MC

Supply is the amount of output for every possible price. Therefore:If P = P1, then q = q1

If P = P2, then q = q2

A Competitive Firm’sShort-Run Supply Curve

Chapter 8 Slide 30


Price($ per

unit)

Output

MC

AVC

ATC

P = AVCWhat happens

if P < AVC?

P2

q2

P1

q1

The firm chooses theoutput level where MR = MC,as long as the firm is able to

cover its variable cost of production.

Chapter 8 Slide 31

Price($ per

unit)

MC

Output

AVC

ATC

P = AVC

P1

P2

q1 q2

S = MC above AVC


Shut-down

Chapter 8 Slide 32

Observations: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.


Chapter 8 Slide 33

Firm’s Response to an Input Price ChangeWhen the price of a firm’s product

changes, the firm changes its output level, so that the marginal cost of production remains equal to the price.

How does the firm's output decision change in response to a change in the prices of one of the firm's inputs?


Chapter 8 Slide 34

MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input Price

Price($ per

unit)

Output

$5

Savings to the firmfrom reducing output

Chapter 8 Slide 35

The short-run market supply curve shows the amount of output that the industry will produce in the short-run for every possible price.

Consider, for simplicity, a competitive market with three firms:

The Short-Run Market Supply Curve

Chapter 8 Slide 36

MC3

Industry Supply in the Short Run

$ perunit

0 2 4 8 105 7 15 21

MC1SSThe short-run

industry supply curveis the horizontal

summation of the supplycurves of the firms.

Quantity

MC2

P1

P3

P2

Question: If increasingoutput raises inputcosts, what impactwould it have on market supply?

Chapter 8 Slide 37

Producer Surplus in the Short RunFirms earn a surplus on all but the last unit

of output.

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.


Chapter 8 Slide 38

AA

DD

BB

CC

ProducerProducerSurplusSurplus

Alternatively, VC is thesum of MC or ODCq* .R is P x q* or OABq*.Producer surplus =

R - VC or ABCD.

Producer Surplus for a Firm

Price($ per

unit ofoutput)

Output

AVCAVCMCMC

00

PP

qq**

At q* MC = MR.Between 0 and q ,

MR > MC for all units.

Chapter 8 Slide 39

Producer Surplus in the Short-Run

Short-run with positive fixed cost


VC- R PS Surplus Producer

FC - VC- R - Profit

PS

Chapter 8 Slide 40

DD

PP**

QQ**

ProducerProducerSurplusSurplus

Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a Market

Price($ per

unit ofoutput)

Output

SS

Chapter 8 Slide 41

Choosing Output in the Long Run

In the long run, a firm can alter all its inputs, including the size of the plant.

We assume free entry and free exit.

Chapter 8 Slide 42

q1

A

BC

D

In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.Profit is equal to ABCD.

Output Choice in the Long Run

Price($ per

unit ofoutput)

Output

P = MR$40

SACSMC

In the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

q3q2

G F$30

LAC

E

LMC

Chapter 8 Slide 43

q1

A

BC

D

Output Choice in the Long Run

Price($ per

unit ofoutput)

Output

P = MR$40

SACSMC

Question: Is the producer makinga profit after increased output

lowers the price to $30?

q3q2

G F$30

LAC

E

LMC

Chapter 8 Slide 44


Entry and ExitThe 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.

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

S1

Long-Run Competitive Equilibrium

Output Output

$ per unit ofoutput

$ per unit ofoutput

$40LAC

LMC

D

S2

P1

Q1q2

Firm Industry

$30

Q2

P2

•Profit attracts firms•Supply increases until profit = 0

Chapter 8 Slide 46


Long-Run Competitive Equilibrium

1) MC = MR

2) P = LAC

No incentive to leave or enter

Profit = 0

3) Equilibrium Market Price

Chapter 8 Slide 47

The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices the firms must pay for inputs.

The Industry’s Long-Run Supply Curve

Chapter 8 Slide 48

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.

Long-Run Supply in aConstant-Cost Industry

AP1

AC

P1

MC

q1

D1

S1

Q1

C

D2

P2P2

q2

B

S2

Q2

Economic profits attract newfirms. Supply increases to S2 and

the market returns to long-run equilibrium.

Long-Run Supply in aConstant-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

SL

Q1 increase to Q2.Long-run supply = SL = LRAC.

Change in output has no impact on input cost.

Chapter 8 Slide 50

In a increasing-cost industry, long-run supply curve is upward sloping.

Long-Run Supply in aIncreasing-Cost Industry

Long-Run Supply in anIncreasing-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput S1

D1

P1

LAC1

P1

SMC1

q1 Q1

A

SSLL

P3

SMC2

Due to the increasein input prices, long-runequilibrium occurs at

a higher price.

LAC2

B

S2

P3

Q3q2

P2 P2

D2

Q2

Chapter 8 Slide 52

In a decreasing-cost industry, long-run supply curve is downward sloping.

Long-Run Supply in aIncreasing-Cost Industry

S2

B

SL

P3

Q3

SMC2

P3

LAC2

Due to the decreasein input prices, long-runequilibrium occurs at

a lower price.

Long-Run Supply in anDecreasing-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

P1P1

SMC1

A

D1

S1

Q1q1

LAC1

Q2q2

P2 P2

D2

Chapter 8 Slide 54

The Effects of a TaxNow, we will consider how a firm responds

to a tax on its output.

The Industry’sLong-Run Supply Curve

Chapter 8 Slide 55

Effect of an Output Tax on a Competitive Firm’s Output

Price($ per

unit ofoutput)

Output

AVC1

MC1

P1

q1

The firm willreduce output to

the point at whichthe marginal cost

plus the tax equalsthe price.

q2

tt

MC2 = MC1 + tax

AVC2

An output taxraises the firm’s

marginal cost by theamount of the tax.

Chapter 8 Slide 56

Effect of an OutputTax on Industry Output

Price($ per

unit ofoutput)

Output

DD

P1

SS1

Q1

P2

Q2

SS2 = S1 + t

t

Tax shifts S1 to S2 andoutput falls to Q2. Price

increases to P2.

Chapter 8 Slide 57

Summary

The managers of firms can operate in accordance with a complex set of objectives and under various constraints.

A competitive market makes its output choice under the assumption that the demand for its own output is horizontal.

Chapter 8 Slide 58

Summary

In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost.

The short-run market supply curve is the horizontal summation of the supply curves of the firms in an industry.

Chapter 8 Slide 59

Summary

The producer surplus for a firm is the difference between revenue of a firm and the minimum cost that would be necessary to produce the profit-maximizing output.

Chapter 8 Slide 60

Summary

In the long-run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost.

The long-run supply curve for a firm can be horizontal, upward sloping, or downward sloping.

End of Chapter 8Profit Maximization

and Competitive Supply

Profit Maximization and Competitive

Supply

chapter 8

Documents

profit maximizationchapter

marginal cost

profit maximizationdetermining

profit maximizationdo

additional revenue

decreasingmarginal revenue

increasingmarginal revenue

maximizedmarginal revenue