Profit Maximization and Competitive Supply Chapter 8 Profit Maximization and Competitive Supply 1

Topics to be Discussed Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run Chapter 8 2

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 3

Perfectly Competitive Markets Characteristics of Perfectly Competitive Markets 1) Price taking 2) Product homogeneity 3) Free entry and exit Chapter 8 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 8 4

Perfectly Competitive Markets Product Homogeneity The products of all firms are perfect substitutes. Examples Agricultural products, oil, copper, iron, lumber Chapter 8 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 8 4

Perfectly Competitive Markets Discussion Questions What are some barriers to entry and exit? Are all markets competitive? When is a market highly competitive? Chapter 8 4

Profit Maximization Do firms maximize profits? Possibility of other objectives Revenue maximization Dividend maximization Short-run profit maximization Chapter 8 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 Chapter 8 6

Profit Maximization Do firms maximize profits? Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior. Chapter 8 7

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 8 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 8 10

Profit Maximization in the Short Run C(q) Total Cost Slope of C(q) = MC Why is cost positive when q is zero? Cost, Revenue, Profit $ (per year) Output (units per year) Chapter 8 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 8 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 8 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 8 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 8 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 8 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 8 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 8 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 8 22

Marginal Revenue, Marginal Cost, and Profit Maximization Chapter 8 23

Marginal Revenue, Marginal Cost, and Profit Maximization Chapter 8 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 8 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) 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 8 28

Marginal Revenue, Marginal Cost, and Profit Maximization The Competitive Firm The competitive firm’s demand If the producers tries to lower price he cannot increase sales P = D = MR = AR Chapter 8 28

Marginal Revenue, Marginal Cost, and Profit Maximization The Competitive Firm Profit Maximization MC(q) = MR = P Chapter 8 29

Choosing Output in the Short Run We will combine production and cost analysis with demand to determine output and profitability. Chapter 8 30

A Competitive Firm Making a Positive Profit MC Price ($ per unit) 60 q0 Lost profit for qq < q* q2 > q* q1 q2 50 AVC ATC At q*: MR = MC and P > ATC 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 8 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 Losses = P- AC) x q* or ABCD Would this producer continue to produce with a loss? Output Chapter 8 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 8 40

The Short-Run Output of an Aluminum Smelting Plant Observations Price between $1140 & $1300: q = 600 Price > $1300: q = 900 Price < $1140: q = 0 Question Should the firm stay in business when P < $1140? Cost (dollars per item) 1400 P1 P2 1300 1200 1140 1100 Output (tons per day) 300 600 900 Chapter 8

Some Cost Considerations for Managers Three guidelines for estimating marginal cost: 1) Average variable cost should not be used as a substitute for marginal cost. Chapter 8 41

Some Cost Considerations for Managers Three guidelines for estimating marginal cost: 2) A single item on a firm’s accounting ledger may have two components, only one of which involves marginal cost. Chapter 8 41

Some Cost Considerations for Managers Three guidelines for estimating marginal cost: 3) All opportunity cost should be included in determining marginal cost. Chapter 8 42

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 8 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 8 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 8 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 8 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, so that the marginal cost of production remains equal to the price. Chapter 8 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 8 54

The Short-Run Production of Petroleum Products Cost ($ per barrel) How much would be produced if P = $23? P = $24-$25? The MC of producing a mix of petroleum products from crude oil increases sharply at several levels of output as the refinery shifts from one processing unit to another. 27 SMC 26 25 24 Output (barrels/day) 23 8,000 9,000 10,000 11,000 Chapter 8 57

The Short-Run Production of Petroleum Products Stepped SMC indicates a different production (cost) process at various capacity levels. Observation: With a stepped MC function, small changes in price may not trigger a change in output. Chapter 8 58

The Short-Run Production of Petroleum Products 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: Chapter 8 59

Industry Supply in the Short Run industry supply curve is the horizontal summation of the supply curves of the firms. MC1 MC2 $ per unit MC3 P1 P3 P2 Question: If increasing output raises input costs, what impact would it have on market supply? 2 4 5 7 8 10 15 Quantity 21 Chapter 8 64

The Short-Run Market Supply Curve Elasticity of Market Supply Chapter 8 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 8 67

The Short-Run Market Supply Curve Questions 1) Give an example of a perfectly inelastic supply. 2) If MC rises rapidly, would the supply be more or less elastic? Chapter 8 68

The World Copper Industry (1999) Annual Production Marginal Cost Country (thousand metric tons) (dollars/pound) Australia 600 0.65 Canada 710 0.75 Chile 3660 0.50 Indonesia 750 0.55 Peru 450 0.70 Poland 420 0.80 Russia 450 0.50 United States 1850 0.70 Zambia 280 0.55 Chapter 8

The Short-Run World Supply of Copper Price ($ per pound) 0.90 MCC,MCR MCJ,MCZ MCA MCP,MCUS MCCa MCPo 0.80 0.70 0.60 0.50 0.40 2000 4000 6000 8000 10000 Production (thousand metric tons) Chapter 8

The Short-Run Market Supply Curve Producer Surplus in the Short Run Firms 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 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 8 73

The Short-Run Market Supply Curve Producer Surplus in the Short-Run Chapter 8 69

The Short-Run Market Supply Curve Observation Short-run with positive fixed cost Chapter 8 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 8 77

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 78

Output Choice in the Long Run Price ($ per unit of output) In the long run, the plant size will be increased and output increased to q3. Long-run profit, EFGD > short run profit ABCD. q3 q2 G F $30 LAC E LMC SAC SMC q1 A B C D In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. P = MR $40 Output Chapter 8 84

Output Choice in the Long Run Price ($ per unit of output) Question: Is the producer making a profit after increased output lowers the price to $30? $30 LAC E LMC SAC SMC D A P = MR $40 C B G F q1 q2 q3 Output Chapter 8 84

Choosing Output in the Long Run Accounting Profit & Economic Profit Accounting profit = R - wL Economic profit = R = wL - rK wl = labor cost rk = opportunity cost of capital Chapter 8 87

Choosing Output in the Long Run Long-Run Competitive Equilibrium Zero-Profit If R > wL + rk, economic profits are positive If R = wL + rk, zero economic profits, but the firms is earning a normal rate of return; indicating the industry is competitive If R < wl + rk, consider going out of business Chapter 8 88

Choosing Output in the Long Run Long-Run Competitive Equilibrium Entry and Exit The 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. Chapter 8 89

Long-Run Competitive Equilibrium $30 Q2 P2 Profit attracts firms Supply increases until profit = 0 $ per unit of output Firm $ per unit of output Industry S1 D LAC LMC $40 P1 Q1 S2 q2 Output Output 92

Choosing Output in the Long Run Long-Run Competitive Equilibrium 1) MC = MR 2) P = LAC No incentive to leave or enter Profit = 0 3) Equilibrium Market Price Chapter 8 93

Choosing Output in the Long Run Questions 1) Explain the market adjustment when P < LAC and firms have identical costs. 2) Explain the market adjustment when firms have different costs. 3) What is the opportunity cost of land? Chapter 8 94

Choosing Output in the Long Run Economic Rent Economic rent is the difference between what firms are willing to pay for an input less the minimum amount necessary to obtain it. Chapter 8 95

Choosing Output in the Long Run An Example Two firms A & B Both own their land A is located on a river which lowers A’s shipping cost by $10,000 compared to B. The demand for A’s river location will increase the price of A’s land to $10,000 Chapter 8 95

Choosing Output in the Long Run An Example Economic rent = $10,000 $10,000 - zero cost for the land Economic rent increases Economic profit of A = 0 Chapter 8 95

Firms Earn Zero Profit in Long-Run Equilibrium $7 1.0 A baseball team in a moderate-sized city sells enough tickets so that price is equal to marginal and average cost (profit = 0). Ticket Price LAC LMC Season Tickets Sales (millions) Chapter 8 96

Firms Earn Zero Profit in Long-Run Equilibrium Ticket Price $7 LAC LMC 1.3 $10 Economic Rent A team with the same cost in a larger city sells tickets for $10. Season Tickets Sales (millions) Chapter 8 97

Firms Earn Zero Profit in Long-Run Equilibrium With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input. Chapter 8 98

Firms Earn Zero Profit in Long-Run Equilibrium If the opportunity cost of the input (rent) is not taken into consideration it may appear that economic profits exist in the long-run. Chapter 8 99

The Industry’s Long-Run Supply Curve 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. Chapter 8 101

The Industry’s Long-Run Supply Curve To determine long-run supply, we assume: All firms have access to the available production technology. Output is increased by using more inputs, not by invention. Chapter 8 100

The Industry’s Long-Run Supply Curve To determine long-run supply, we assume: The market for inputs does not change with expansions and contractions of the industry. Chapter 8 100

Long-Run Supply in a Constant-Cost Industry B S2 Q2 Economic profits attract new firms. Supply increases to S2 and the market returns to long-run equilibrium. SL Q1 increase to Q2. Long-run supply = SL = LRAC. Change in output has no impact on input cost. $ per unit of output $ per unit of output A P1 AC MC q1 D1 S1 Q1 C D2 P2 q2 Output Output 106

Long-Run Supply in a Constant-Cost Industry 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. Chapter 8 100

Long-Run Supply in an Increasing-Cost Industry SL P3 SMC2 Due to the increase in input prices, long-run equilibrium occurs at a higher price. LAC2 $ per unit of output $ per unit of output S1 D1 P1 LAC1 SMC1 q1 Q1 A B S2 P3 Q3 q2 P2 D1 Q2 Output Output 111

Long-Run Supply in a Increasing-Cost Industry In a increasing-cost industry, long-run supply curve is upward sloping. Chapter 8 100

The Industry’s Long-Run Supply Curve Questions 1) Explain how decreasing-cost is possible. 2) Illustrate a decreasing cost industry. 3) What is the slope of the SL in a decreasing-cost industry? Chapter 8 112

Long-Run Supply in an Decreasing-Cost Industry B SL P3 Q3 SMC2 LAC2 Due to the decrease in input prices, long-run equilibrium occurs at a lower price. $ per unit of output $ per unit of output P1 SMC1 A D1 S1 Q1 q1 LAC1 Q2 q2 P2 D2 Output Output 117

Long-Run Supply in a Increasing-Cost Industry In a decreasing-cost industry, long-run supply curve is downward sloping. Chapter 8 100

The Industry’s Long-Run Supply Curve The Effects of a Tax In an earlier chapter we studied how firms respond to taxes on an input. Now, we will consider how a firm responds to a tax on its output. Chapter 8 118

Effect of an Output Tax on a Competitive Firm’s Output Price ($ per unit of output) t MC2 = MC1 + tax AVC2 An output tax raises the firm’s marginal cost by the amount of the tax. The firm will reduce output to the point at which the marginal cost plus the tax equals the price. q2 AVC1 MC1 P1 q1 Output Chapter 8 121

Effect of an Output Tax on Industry Output Price ($ per unit of output) S2 = S1 + t t Tax shifts S1 to S2 and output falls to Q2. Price increases to P2. P1 S1 Q1 D P2 Q2 Output Chapter 8 124

The Industry’s Long-Run Supply Curve Long-Run Elasticity of Supply 1) Constant-cost industry Long-run supply is horizontal Small increase in price will induce an extremely large output increase Chapter 8 130

The Industry’s Long-Run Supply Curve Long-Run Elasticity of Supply 1) Constant-cost industry Long-run supply elasticity is infinitely large Inputs would be readily available Chapter 8 130

The Industry’s Long-Run Supply Curve Long-Run Elasticity of Supply 2) Increasing-cost industry Long-run supply is upward-sloping and elasticity is positive The slope (elasticity) will depend on the rate of increase in input cost Long-run elasticity will generally be greater than short-run elasticity of supply Chapter 8 131

The Industry’s Long-Run Supply Curve Question: Describe the long-run elasticity of supply in a decreasing -cost industry. Chapter 8 132

The Long-Run Supply of Housing Scenario 1: Owner-occupied housing Suburban or rural areas National market for inputs Chapter 8 133

The Long-Run Supply of Housing Questions Is this an increasing or a constant-cost industry? What would you predict about the elasticity of supply? Chapter 8 133

The Long-Run Supply of Housing Scenario 2: Rental property Zoning restrictions apply Urban location High-rise construction cost Chapter 8 134

The Long-Run Supply of Housing Questions Is this an increasing or a constant-cost industry? What would you predict about the elasticity of supply? Chapter 8 134

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 8 139

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 8 140

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. Economic rent is the payment for a scarce resource of production less the minimum amount necessary to hire that factor. Chapter 8 141

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. Chapter 8 142

Profit Maximization and Competitive Supply End of Chapter 8 Profit Maximization and Competitive Supply 1