Profit Maximization and Perfect Competition Chapter 7 Profit Maximization and Perfect Competition Chapter 7 1

Perfectly Competitive Markets Characteristics of Perfectly Competitive Markets 1) Price taking 2) Product homogeneity 3) Free entry and exit Chapter 7 4

Perfectly Competitive Markets 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 7 4

Perfectly Competitive Markets Product Homogeneity The products of all firms are perfect substitutes. Examples Agricultural products, oil, copper, iron, Chapter 7 4

Perfectly Competitive Markets Free Entry and Exit Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a market. Chapter 7 4

Profit Maximization Do firms maximize profits? Revenue maximization Dividend maximization Short-run profit maximization Chapter 7 5

Profit Maximization Do firms maximize profits? Implications of non-profit objective Over the long-run investors would not support the company Without profits, survival unlikely Long-run profit maximization is valid Chapter 7 6

Marginal Revenue, Marginal Cost, and Profit Maximization Determining the profit maximizing level of output Profit ( ) = Total Revenue - Total Cost Total Revenue (R) = Pq Total Cost (C) = Cq Therefore: Chapter 7 8

Profit Maximization in the Short Run Cost, Revenue, Profit ($s per year) R(q) Total Revenue Slope of R(q) = MR Output (units per year) Chapter 7 10

Profit Maximization in the Short Run C(q) Total Cost Slope of C(q) = MC Cost, Revenue, Profit $ (per year) Output (units per year) Chapter 7 11

Marginal Revenue, Marginal Cost, and Profit Maximization 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 7 14

Marginal Revenue, Marginal Cost, and Profit Maximization 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 Cost, Revenue, Profit ($s per year) C(q) A B R(q) q0 q* Output (units per year) Chapter 7 16

Marginal Revenue, Marginal Cost, and Profit Maximization Comparing R(q) and C(q) Question: Why is profit negative when output is zero? Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0 q* R(q) Chapter 7 17

Marginal Revenue, Marginal Cost, and Profit Maximization Comparing R(q) and C(q) Output levels: q0 - q* R(q)> C(q) MR > MC Indicates higher profit at higher output Profit is increasing Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0 q* R(q) Chapter 7 18

Marginal Revenue, Marginal Cost, and Profit Maximization Comparing R(q) and C(q) Output level: q* R(q)= C(q) MR = MC Profit is maximized Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0 q* R(q) Chapter 7 19

Marginal Revenue, Marginal Cost, and Profit Maximization Question Why is profit reduced when producing more or less than q*? Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0 q* R(q) Chapter 7 20

Marginal Revenue, Marginal Cost, and Profit Maximization Comparing R(q) and C(q) Output levels beyond q*: R(q)> C(q) MC > MR Profit is decreasing Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0 q* R(q) Chapter 7 21

Marginal Revenue, Marginal Cost, and Profit Maximization Therefore, it can be said: Profits are maximized when MC = MR. Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0 q* R(q) Chapter 7 22

Marginal Revenue, Marginal Cost, and Profit Maximization Chapter 7 23

Marginal Revenue, Marginal Cost, and Profit Maximization Chapter 7 24

Marginal Revenue, Marginal Cost, and Profit Maximization 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 Chapter 7 25

Demand and Marginal Revenue Faced by a Competitive Firm Price $ per bushel Price $ per bushel Firm Industry D $4 d $4 100 200 Output (bushels) 100 Output (millions of bushels) Chapter 7 27

Marginal Revenue, Marginal Cost, and Profit Maximization The Competitive Firm 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. Chapter 7 28

Marginal Revenue, Marginal Cost, and Profit Maximization The Competitive Firm Profit Maximization MC(q) = MR = P Chapter 7 29

Choosing Output in the Short Run We will combine production and cost analysis with demand to determine output and profitability. Chapter 7 30

A Competitive Firm Making a Positive Profit MC Price ($ per unit) 60 q0 Lost profit for q1 < q* q2 > q* q1 q2 50 AVC ATC At q*: MR = MC D A B C q1 : MR > MC and q2: MC > MR and q0: MC = MR but MC falling 40 AR=MR=P q* 30 20 10 1 2 3 4 5 6 7 8 9 10 11 Output Chapter 7 36

A Competitive Firm Incurring Losses AVC ATC MC q* P = MR Price ($ per unit) B F C A E D At q*: MR = MC and P < ATC or ABCD Would this producer continue to produce with a loss? Output Chapter 7 39

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 7 40

A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) P1 q1 The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production. MC AVC ATC P2 q2 P = AVC What happens if P < AVC? Output Chapter 7 46

A Competitive Firm’s Short-Run Supply Curve Observations: P = MR MR = MC P = MC Supply is the amount of output for every possible price. Therefore: If P = P1, then q = q1 If P = P2, then q = q2 Chapter 7 47

A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) S = MC above AVC MC ATC P2 AVC P1 P = AVC Shut-down Output q1 q2 Chapter 7 49

A Competitive Firm’s Short-Run Supply Curve 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 7 50

A Competitive Firm’s Short-Run Supply Curve Firm’s Response to an Input Price Change When the price of a firm’s product changes, the firm changes its output level, Chapter 7 51

The Response of a Firm to a Change in Input Price ($ per unit) MC2 q2 Input cost increases and MC shifts to MC2 and q falls to q2. Savings to the firm from reducing output MC1 q1 $5 Output Chapter 7 54

The Short-Run Market Supply Curve Elasticity of Market Supply Chapter 7 66

The Short-Run Market Supply Curve Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output. Perfectly elastic short-run supply arises when marginal costs are constant. Chapter 7 67

The Short-Run Market Supply Curve Producer Surplus in the Short Run 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 7 69

Producer Surplus for a Firm q* At q* MC = MR. Between 0 and q , MR > MC for all units. Price ($ per unit of output) A D B C Producer Surplus Alternatively, VC is the sum of MC or ODCq* . R is P x q* or OABq*. Producer surplus = R - VC or ABCD. MC AVC Output Chapter 7 73

The Short-Run Market Supply Curve Producer Surplus in the Short-Run Chapter 7 69

Producer Surplus for a Market Price ($ per unit of output) S D P* Q* Producer Surplus Market producer surplus is the difference between P* and S from 0 to Q*. Output Chapter 7 77