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

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

3. 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

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

5. 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

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

7. 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

8. 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

9. 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

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

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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

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

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

21. 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

22. 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

23. 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

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

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

26. A Competitive Firm Making a Positive ProfitMC
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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

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

36. 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

37. 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

38. Producer Surplus for a Firmq*
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

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

40. 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