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

2. 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.

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

4. D = AR = MR

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

6. The neo-classical theory f the firm
Perfect Competition

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

8. 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.

9. 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

10. 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

11. 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

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

13. 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

14. 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