The profit maximising position Neo-classical Theory of the Firm The profit maximising position

The assumptions of the model: 1. All the goods in the market are homogenous. 2. There are many buyers and many sellers. 3. There is perfect information – buyers and sellers know everything and information is symmetric. 4. There are no barriers to entry or exit in the market. 5. There are no transport costs.

On graph paper plot the demand curve, MR and MC curves and find the profit maximising position.

D = AR = MR

Profit Maximisation occurs at the level of output where MC=MR

The neo-classical theory f the firm Perfect Competition

Market Firm X MC P P AC S1 P1 D=AR=MR D1 Qd Q1 Qd

Supernormal profit/Abnormal profit Normal profit is equal to the opportunity cost of being in that business Eg. A businessman earns £30,000 profit per annum running a coffee bar Next best alternative is running a dry cleaners The benefit foregone from the next best alternative is for £28,000 a year Normal profit = £28,000 Supernormal profit = £2,000 (everything above the normal profit Normal profit is therefore included as a cost in average and variable cost curves.

Because there is supernormal profit and perfect information – this attracts new entrants into the market Market Firm X MC P P AC S1 P1 D=AR=MR D1 Qd Q1 Qd

New entrants into the market increase supply and the market price level falls Firm X MC P P AC S1 S2 P2 D=AR=MR D1 Qd Q2 Qd

Now AC is greater than AR so there is a loss – and firms leave the market Firm X MC P P AC S1 S2 P2 D=AR=MR D1 Qd Q2 Qd

Supply in the market falls back to S3 Firm X MC P P AC S3 S2 P3 D=AR=MR D1 Qd Q3 Qd

Now AR = AC and there are only normal profits being made. Market Firm X MC P P AC S3 S2 P3 D=AR=MR D1 Qd Q3 Qd

In the long run only normal profits are made Market Firm X MC P P AC S3 S2 P3 D=AR=MR D1 Qd Q3 Qd In the long run only normal profits are made