MICROECONOMICS: Theory & Applications Chapter 9: Profit Maximization in Perfectly Competitive Markets By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College

Assumptions of Perfect Competition Large numbers of buyers and sellers Free entry and exit Homogeneous products Perfect information Copyright 2012 John Wiley & Sons, Inc.

Profit Maximization ASSUMPTION: firms select an output level so as to maximize profit, defined as the difference between revenue and cost “Survivor Principle” – the observation that in competitive markets, firms that do not approximate profit-maximizing behavior fail, and that survivors are those firms that, intentionally or not, make the appropriate profit-maximizing decisions. Copyright 2012 John Wiley & Sons, Inc.

The Demand Curve for a Competitive Firm Price taker – a firm that takes prices as given and does not expect its output decisions to affect price =>horizontal demand curve Total revenue – price times the quantity sold Average revenue (AR) – total revenue divided by output Marginal revenue (MR) – the change in total revenue when there is a one-unit change in output Copyright 2012 John Wiley & Sons, Inc.

Figure 9.1 - The Competitive Firm’s Demand Curve Copyright 2012 John Wiley & Sons, Inc.

Table 9.1 Copyright 2012 John Wiley & Sons, Inc.

Short-Run Profit Maximization Total profit (π) – the difference between total revenue and total cost TR rises in proportion to output since the price is constant. TC rises slowly at first and then more rapidly as the plant facility becomes more fully utilized and MC rises. Total profit tends to increase and then decrease as more is produced. Copyright 2012 John Wiley & Sons, Inc.

Figure 9.2 - Short-Run Profit Maximization: Total Curves Copyright 2012 John Wiley & Sons, Inc.

Short-Run Profit Maximization Using Per-unit Curves Average profit per unit (π/q) – total profit divided by number of units sold Profit is maximized at the output level where MR=MC. If MR>MC, profits would increase if output were increased. If MR<MC, profits would increase if output were decreased. Copyright 2012 John Wiley & Sons, Inc.

Figure 9.3 - Short-Run Profit Maximization Using Per-unit Curves Copyright 2012 John Wiley & Sons, Inc.

Operating at a Loss in the Short-Run If ATC<AR at the output-level where MC=MR => profit is negative Two choices: Temporarily shut-down Permanently go-out-of-business Question: Which choice will yield smaller loss? Copyright 2012 John Wiley & Sons, Inc.

Figure 9.4 - Operating at a Loss in the Short-Run Copyright 2012 John Wiley & Sons, Inc.

The Perfectly Competitive Firm’s Short-Run Supply Curve Short-run firm supply curve – a graph of the systematic relationship between a product’s price and a firm’s most profitable output level Supply curve = MC curve where MC > minimum point on AVC curve Identifies most profitable output for each possible price Shutdown point – the minimum level of average variable cost below which the firm will cease operations Copyright 2012 John Wiley & Sons, Inc.

Figure 9.5 - The Perfectly Competitive Firm’s Short-Run Supply Curve Copyright 2012 John Wiley & Sons, Inc.

Output Response to a Change in Input Prices Question: What is the impact of a change in input price, holding product price constant? 1) MC will shift 2) Firm will adjust output until MC=MR Copyright 2012 John Wiley & Sons, Inc.

Figure 9.6 - Output Response to a Change in Input Prices Copyright 2012 John Wiley & Sons, Inc.

The Short-Run Industry Supply Curve Short-run industry supply curve – add the quantities produced by each firm by summing the individual firms’ marginal cost curves horizontally Assumption – variable input prices remain constant at all levels of industry output Curve slopes upward due to law of diminishing marginal returns Market price and output: determined by interaction between short-run industry supply curve and the market demand curve Copyright 2012 John Wiley & Sons, Inc.

Figure 9.7 - The Short-Run Competitive Industry Supply Curve Copyright 2012 John Wiley & Sons, Inc.

Long-Run Competitive Equilibrium Allow enough time for all inputs to vary Long-run cost curves include the opportunity cost of inputs Zero economic profit – the point at which total profit is zero since price equals the average cost of production; “normal” economic return No incentive for firms to enter or leave the industry Copyright 2012 John Wiley & Sons, Inc.

Figure 9.8 - Long-Run Profit Maximization Copyright 2012 John Wiley & Sons, Inc.

Long-Run Competitive Equilibrium II Characteristics: The firm is maximizing profit and producing where LMC=price. There is no incentive for firms to enter or leave the industry. The combined quantity of output of all the firms at the prevailing wage equals the total quantity consumers wish to purchase at that price. Copyright 2012 John Wiley & Sons, Inc.

Figure 9.9 – Long-Run Competitive Equilibrium Copyright 2012 John Wiley & Sons, Inc.

Zero Profit When Firms’ Cost Curves Differ? When all firms in a competitive industry have identical cost curves, each firm earns zero economic profit in long-run equilibrium. What happens if cost curves differ among firms? There is a tendency for factor inputs to receive compensation equal to their opportunity costs. This process leads to the zero-profit equilibrium. Copyright 2012 John Wiley & Sons, Inc.

The Long-Run Industry Supply Curve The long-run relationship between price and industry output depends on whether input prices are constant, increasing, or decreasing as the industry expands or contracts Copyright 2012 John Wiley & Sons, Inc.

The Long-Run Industry Supply Curve [Three Classifications] Constant-cost industry: an industry in which expansion of output does not bid up input prices long-run average production cost per unit remains unchanged, and the long-run industry supply curve is horizontal Increasing-cost industry: an industry in which expansion of output leads to higher long-run average production costs the long-run industry supply curve slopes upward Decreasing-cost industry: an industry in which the long-run industry supply curve slopes downward Copyright 2012 John Wiley & Sons, Inc.

Figure 9.10 – Long-Run Supply in a Constant-Cost Industry Copyright 2012 John Wiley & Sons, Inc.

Figure 9.11 – Long-Run Supply in an Increasing-Cost Industry Copyright 2012 John Wiley & Sons, Inc.

Figure 9.12 – Long-Run Supply in an Decreasing-Cost Industry Copyright 2012 John Wiley & Sons, Inc.

Comments on the Long-Run Supply Curve The long-run supply curve is not derived by summing the long-run marginal cost curves of an industry’s firms. A movement along the long-run industry supply curve is accompanied with the assumptions that conditions of supply remain constant, such as: Technology conditions of input supply factors government regulations weather conditions (continued) Copyright 2012 John Wiley & Sons, Inc.

Comments on the Long-Run Supply Curve (continued) Although the industry may never attain a long-run equilibrium in reality, what is important is that there is a tendency for the industry to move in the direction indicated by the theory. Economic profit is zero along a competitive industry’s long-run supply curve. In reality, the process of adjustment from a short-run equilibrium to a long-run equilibrium may vary from the theoretical description. Copyright 2012 John Wiley & Sons, Inc.

When Does the Competitive Model Apply? The assumptions of perfect competition are stringent and are likely to be satisfied fully in very few real-world markets. However, many market come close enough to satisfying the assumptions of perfect competition to make the model useful. And it is useful to assess the effect of deviations from the assumptions in a real-world market. Copyright 2012 John Wiley & Sons, Inc.

Copyright © 2012 John Wiley & Sons, Inc. All rights reserved Copyright © 2012 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. Copyright 2012 John Wiley & Sons, Inc.