Chapter 8Slide 1 Topics to be Discussed Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run

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

Chapter 8Slide 4 Profit Maximization Do firms maximize profits? Possibility of other objectives  Revenue maximization  Dividend maximization  Short-run profit maximization

Chapter 8Slide 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 8Slide 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 8Slide 7 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. Marginal Revenue, Marginal Cost, and Profit Maximization

Chapter 8Slide 8 Profits are maximized when MC = MR. Marginal Revenue, Marginal Cost, and Profit Maximization R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q*

Chapter 8Slide 9 Marginal Revenue, Marginal Cost, and Profit Maximization

Chapter 8Slide 10 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 Marginal Revenue, Marginal Cost, and Profit Maximization

Chapter 8Slide 11 q0q0 Lost profit for q q < q * Lost profit for q 2 > q * q1q1 q2q2 A Competitive Firm Making a Positive Profit Price ($ per unit) MC AVC ATC AR=MR=P Output q*q* At q * : MR = MC and P > ATC D A B C q 1 : MR > MC and q 2 : MC > MR and q 0 : MC = MR but MC falling

Chapter 8Slide 12 Would this producer continue to produce with a loss? A Competitive Firm Incurring Losses Price ($ per unit) Output AVC ATC MC q*q* P = MR B F C A E D At q * : MR = MC and P < ATC Losses = P- AC) x q * or ABCD

Chapter 8Slide 13 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 8Slide 14 Price ($ per unit) MC Output AVC ATC P = AVC P1P1 P2P2 q1q1 q2q2 S = MC above AVC A Competitive Firm’s Short-Run Supply Curve Shut-down

Chapter 8Slide 15 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

Chapter 8Slide 16 MC 3 Industry Supply in the Short Run $ per unit MC 1 S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. Quantity MC 2 P1P1 P3P3 P2P2 Question: If increasing output raises input costs, what impact would it have on market supply?

Chapter 8Slide 17 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. The Short-Run Market Supply Curve

Chapter 8Slide 18 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. The Short-Run Market Supply Curve

Chapter 8Slide 19 A D B CProducerSurplus Alternatively, VC is the sum 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 of output) OutputAVCMC0 P q*q*q*q* At q * MC = MR. Between 0 and q, MR > MC for all units.

Chapter 8Slide 20 Producer Surplus in the Short-Run The Short-Run Market Supply Curve

Chapter 8Slide 21 D P*P*P*P* Q*Q*Q*Q* ProducerSurplus Market producer surplus is the difference between P* and S from 0 to Q *. Producer Surplus for a Market Price ($ per unit of output) OutputS

Chapter 8Slide 22 Choosing Output in the Long Run 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. Long-Run Competitive Equilibrium

S1S1 Output $ per unit of output $ per unit of output $40 LAC LMC D S2S2 P1P1 Q1Q1 q2q2 FirmIndustry $30 Q2Q2 P2P2 Profit attracts firms Supply increases until profit = 0

Chapter 8Slide 24 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 8Slide 25 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 8Slide 26 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 8Slide 27 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 If the opportunity cost of the input (rent) is not taken into consideration it may appear that economic profits exist in the long-run.

A P1P1 AC P1P1 MC q1q1 D1D1 S1S1 Q1Q1 C D2D2 P2P2 P2P2 q2q2 B S2S2 Q2Q2 Economic profits attract new firms. Supply increases to S 2 and the market returns to long-run equilibrium. Long-Run Supply in a Constant-Cost Industry Output $ per unit of output $ per unit of output SLSL Q 1 increase to Q 2. Long-run supply = S L = LRAC. Change in output has no impact on input cost.

Chapter 8Slide 29 Effect of an Output Tax on a Competitive Firm’s Output Price ($ per unit of output) Output AVC 1 MC 1 P1P1 q1q1 The firm will reduce output to the point at which the marginal cost plus the tax equals the price. q2q2 t MC 2 = MC 1 + tax AVC 2 An output tax raises the firm’s marginal cost by the amount of the tax.

Chapter 8Slide 30 Effect of an Output Tax on Industry Output Price ($ per unit of output) Output D P1P1 SS1SS1 Q1Q1 P2P2 Q2Q2 S S 2 = S 1 + t t Tax shifts S 1 to S 2 and output falls to Q 2. Price increases to P 2.

Chapter 8Slide 31 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 8Slide 32 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 8Slide 33 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.