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

2. 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

3. 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

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

5. 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

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

7. 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

8. 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

9. Profit Maximization Do firms maximize profits?
Possibility of other objectives
Revenue maximization
Dividend maximization
Short-run profit maximization
Chapter 8 5

10. 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

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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

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

24. Marginal Revenue, Marginal Cost, and Profit Maximization
Chapter 8 24

25. 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

26. 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

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

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

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

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

31. A Competitive Firm Making a Positive ProfitMC
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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. The Short-Run Market Supply Curve
Elasticity of Market Supply
Chapter 8 66

49. 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

50. 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

51. The World Copper Industry (1999)
Annual Production Marginal Cost
Country (thousand metric tons) (dollars/pound)
Australia
Canada
Chile
Indonesia
Peru
Poland
Russia
United States
Zambia
Chapter 8

52. 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

53. 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

54. 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 8 73

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

56. The Short-Run Market Supply Curve
Observation
Short-run with positive fixed cost
Chapter 8 69

57. 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

58. 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

59. 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

60. 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

61. 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

62. 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

63. 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

64. 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

65. 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

66. 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

67. 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

68. 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

69. 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

70. 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

71. 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

72. 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

73. 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

74. 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

75. 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

76. 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

77. Long-Run Supply in a Constant-Cost IndustryB 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

78. 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

79. Long-Run Supply in an Increasing-Cost IndustrySL 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

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

81. 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

82. Long-Run Supply in an Decreasing-Cost IndustryB 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

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

84. 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

85. 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

86. 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

87. 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

88. 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

89. 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

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

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

92. 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

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

94. 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

95. 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

96. 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

97. 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

98. 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

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