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

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
The model of perfect competition can be used to study a variety of markets
Basic assumptions of Perfectly Competitive Markets
Price taking
Product homogeneity
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.
Each firm takes market price as given – price taker
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.
Product quality is relatively similar as well as other product characteristics
Agricultural products, oil, copper, iron, lumber
Heterogeneous products, such as brand names, can charge higher prices because they are perceived as better
Chapter 8 4

7. Perfectly Competitive Markets
Free Entry and Exit
When there are no special costs that make it difficult for a firm to enter (or exit) an industry
Buyers can easily switch from one supplier to another.
Suppliers can easily enter or exit a market.
Pharmaceutical companies not perfectly competitive because of the large costs of R&D required
Chapter 8 4

8. When are Markets Competitive
Few real products are perfectly competitive
Many markets are, however, highly competitive
They face relatively low entry and exit costs
Highly elastic demand curves
No rule of thumb to determine whether a market is close to perfectly competitive
Depends on how they behave in situations
Chapter 8

9. Profit Maximization Do firms maximize profits?
Managers in firms may be concerned with other objectives
Revenue maximization
Revenue growth
Dividend maximization
Short-run profit maximization (due to bonus or promotion incentive)
Could be at expense of long run profits
Chapter 8 5

10. Profit Maximization Implications of non-profit objective
Over the long-run investors would not support the company
Without profits, survival unlikely in competitive industries
Managers have constrained freedom to pursue goals other than long-run profit maximization
Chapter 8 6

11. Marginal Revenue, Marginal Cost, and Profit Maximization
We can study profit maximizing output for any firm whether perfectly competitive or not
Profit () = Total Revenue - Total Cost
If q is output of the firm, then total revenue is price of the good times quantity
Total Revenue (R) = Pq
Chapter 8 8

12. Marginal Revenue, Marginal Cost, and Profit Maximization
Costs of production depends on output
Total Cost (C) = Cq
Profit for the firm, , is difference between revenue and costs
Chapter 8

13. Marginal Revenue, Marginal Cost, and Profit Maximization
Firm selects output to maximize the difference between revenue and cost
We can graph the total revenue and total cost curves to show maximizing profits for the firm
Distance between revenues and costs show profits
Chapter 8

14. Marginal Revenue, Marginal Cost, and Profit Maximization
Revenue is curved showing that a firm can only sell more if it lowers its price
Slope in revenue curve is the marginal revenue
Change in revenue resulting from a one-unit increase in output
Slope of total cost curve is marginal cost
Additional cost of producing an additional unit of output
Chapter 8

15. Marginal Revenue, Marginal Cost, and Profit Maximization
If the producer tries to raise price, sales are zero.
Profit is negative to begin with since revenue is not large enough to cover fixed and variable costs
As output rises, revenue rises faster than costs increasing profit
Profit increases until it is maxed at q*
Profit is maximized where MR = MC or where slopes of the R(q) and C(q) curves are equal
Chapter 8

16. Profit Maximization – Short Run
Profits are maximized where MR (slope at A) and MC (slope at B) are equal
Cost,
Revenue,
Profit
($s per year)
Profits are maximized where R(q) – C(q) is maximized
C(q) A
R(q) q* B q0
(q)
Output
Chapter 8 10

17. Marginal Revenue, Marginal Cost, and Profit Maximization
Profit is maximized at the point at which an additional increment to output leaves profit unchanged
Chapter 8

18. Marginal Revenue, Marginal Cost, and Profit Maximization
The Competitive Firm
Price taker – market price and output determined from total market demand and supply
Market output (Q) and firm output (q)
Market demand (D) and firm demand (d)
Chapter 8 25

19. The Competitive Firm
Demand curve faced by an individual firm is a horizontal line
Firm’s sales have no effect on market price
Demand curve faced by whole market is downward sloping
Shows amount of good all consumers will purchase at different prices
Chapter 8

20. The Competitive Firm 100 200 Firm 100 Industry D S d $4 $4 Output
(bushels)
Price
$ per
bushel
100
200
Firm
Price
$ per
bushel
Output
(millions
of bushels)
100
Industry D S d $4 $4
Chapter 8

21. The Competitive Firm The competitive firm’s demand
Individual producer sells all units for $4 regardless of that producer’s level of output.
MR = P with the horizontal demand curve
For a perfectly competitive firm, profit maximizing output occurs when
Chapter 8 28

22. Choosing Output: Short Run
We will combine revenue and costs with demand to determine profit maximizing output decisions.
In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits.
We can look at the graph of MR, MC, ATC and AVC to determine profits
Chapter 8 30

23. Choosing Output: Short Run
The point where MR = MC, the profit maximizing output is chosen
MR=MC at quantity, q*, of 8
At a quantity less than 8, MR>MC so more profit can be gained by increasing output
At a quantity greater than 8, MC>MR, increasing output will decrease profits
Chapter 8

24. A Competitive Firm MC q2 AR=MR=P q1 q* Output 10 20 30 40 Price 50 AVC
Lost Profit for q2>q*
Lost Profit for q2>q*
AVC
ATC A
AR=MR=P q1 q*
q1 : MR > MC
q2: MC > MR
q0: MC = MR 1 2 3 4 5 6 7 8 9 10 11
Output
Chapter 8 36

25. A Competitive Firm – Positive Profitsq2 MC
AVC
ATC q*
AR=MR=P A q1 10 20 30 40
Price 50
Total Profit = ABCD D C
Profits are determined by output per unit times quantity B
Profit per unit = P-AC(q) = A to B 1 2 3 4 5 6 7 8 9 10 11
Output
Chapter 8 36

26. The Competitive Firm A firm does not have to make profits
It is possible a firm will incur losses if the P < AC for the profit maximizing quantity
Still measured by profit per unit times quantity
Profit per unit is negative (P – AC < 0)
Chapter 8

27. A Competitive Firm – LossesMC
AVC
ATC
Price B C
P = MR D q* A
At q*: MR = MC and P < ATC
Losses = (P- AC) x q* or ABCD
Output
Chapter 8 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 P < ATC the firm is making losses
Chapter 8 40

29. Short Run Production When should the firm shut down?
If AVC < P < ATC the firm should continue producing in the short run
Can cover some of its fixed costs and all of its variable costs so the loss is small than the fixed costs if no production
If AVC > P < ATC the firm should shut-down.
Can not cover even its fixed costs
Chapter 8

30. A Competitive Firm – Losses
Price MC
AVC
ATC
P = MR D q* A B C
Losses
P < ATC but
AVC so firm will continue to produce in short run E F
Output
Chapter 8 39

31. Some Cost Considerations for Managers
Three guidelines for estimating marginal cost:
Average variable cost should not be used as a substitute for marginal cost.
A single item on a firm’s accounting ledger may have two components, only one of which involved marginal cost
All opportunity costs should be included in determining marginal cost
Chapter 8 41

32. Competitive Firm – Short Run Supply
Supply curve tells how much output will be produced at different prices
Competitive firms determine quantity to produce where P = MC
Firm shuts down when P < AVC
Competitive firms supply curve is portion of the marginal cost curve above the AVC curve
Chapter 8

33. A Competitive Firm’s Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the
output level where P = MR = MC,
as long as P > AVC.
Supply is MC above AVC S MC P2 q2
AVC
ATC P1 q1
P = AVC
Output
Chapter 8 46

34. A Competitive Firm’s Short-Run Supply Curve
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

35. A Competitive Firm’s Short-Run Supply Curve
Over time prices of product and inputs can change
How does the firm’s output change in response to a change in the price of an input.
We can show an increase in marginal costs and the change in the firms output decisions
Chapter 8 51

36. The Response of a Firm to a Change in Input Price
($ per
unit)
MC2
Input cost increases
and MC shifts to MC2
and q falls to q2.
Savings to the firm
from reducing output
MC1 $5 q2 q1
Output
Chapter 8 54

37. Short-Run Market Supply Curve
Shows the amount of product the whole market will produce at given prices
Is the sum of all the individual producers in the market
We can show graphically how we can sum the supply curves of individual producers
Chapter 8

38. Industry Supply in the Short Run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
MC1
MC2
MC3
$ per
unit P3 10 8 2 4 7 5 15 21 P2 P1 Q
Chapter 8 64

39. The Short-Run Market Supply Curve
As price rises, firms expand their production
Increased production leads to increased demand for inputs and could cause increases in input prices
Increases in input prices cause MC curve to rise
This lowers each firm’s output choice
Causes industry supply to be less responsive to change in price than would be otherwise
Chapter 8 66

40. Elasticity of Market Supply
Measures the sensitivity of industry output to market price
The percentage change in quantity supplied, Q, in response to 1-percent change in price
Chapter 8

41. Elasticity of Market Supply
When MC increase rapidly in response to increases in output, elasticity is low
When MC increase slowly, supply is relatively elastic
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

42. Producer Surplus in the Short Run
Price is greater than MC on all but the last unit of output.
Therefore, surplus is earned on all but the last unit
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.
Area above supply to the market price
Chapter 8 69

43. Producer Surplus for a Firm
Price
($ per
unit of
output)
AVC MC
Producer
Surplus A B P q*
At q* MC = MR.
Between 0 and q ,
MR > MC for all units.
Producer surplus is area above MC to the price
Output
Chapter 8 73

44. The Short-Run Market Supply Curve
Sum of MC from 0 to q*, it is the sum o the total variable cost of producing q*
Producer Surplus can be defined as difference between the firm’s revenue and it total variable cost
We can show this graphically by the rectangle ABCD
Revenue (0ABq*) minus variable cost (0DCq*)
Chapter 8 69

45. Producer Surplus for a Firm
Price
($ per
unit of
output)
Producer
Surplus
AVC MC A B P q*
Producer surplus is also ABCD = Revenue minus variable costs C D
Output
Chapter 8 73

46. Producer Surplus versus Profit
Profit is revenue minus total cost (not just variable cost)
When fixed cost is positive, producer surplus is greater than profit
Chapter 8

47. Producer Surplus versus Profit
Costs of production determine magnitude of producer surplus
Higher costs firms have less producer surplus
Lower cost firms have more producer surplus
Adding up surplus for all producers in the market given total market producer surplus
Area below market price and above supply curve
Chapter 8

48. Producer Surplus for a Market
Price
($ per
unit of
output) S D
Market producer surplus is
the difference between P*
and S from 0 to Q*. P* Q*
Producer
Surplus
Output
Chapter 8 77

49. Choosing Output in the Long Run
In short run, one or more inputs are fixed
Depending on the time, it may limit the flexibility of the firm
In the long run, a firm can alter all its inputs, including the size of the plant.
We assume free entry and free exit.
No legal restrictions or extra costs
Chapter 8 78

50. Choosing Output in the Long Run
In the short run a firm faces a horizontal demand curve
Take market price as given
The short-run average cost curve (SAC) and short run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)
The long run average cost curve (LRAC)
Economies of scale to q2
Diseconomies of scale after q2
Chapter 8

51. Output Choice in the Long Run
Price
$30
LAC
LMC
SAC
SMC A D
P = MR
$40 q1 q3 B C q2
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
Output
Chapter 8 84

52. Output Choice in the Long Run
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
Price q1 B C A D
P = MR
$40
SAC
SMC q3 q2
$30
LAC
LMC F G
Output
Chapter 8 84

53. Long-Run Competitive Equilibrium
For long run equilibrium, firms must have no desire to enter or leave the industry
We can relate economic profit to the incentive to enter and exit the market
Need to relate accounting profit to economic profit
Chapter 8 87

54. Long-run Competitive Equilibrium
Accounting profit
Difference between firm’s revenues and direct costs
Economic profit
Difference between firm’s revenues and direct and indirect costs
Takes into account opportunity costs
Chapter 8

55. Long-run Competitive Equilibrium
Firm uses labor (L) and capital (K) with purchased capital
Accounting Profit & Economic Profit
Accounting profit:  = R - wL
Economic profit:  = R = wL - rK
wl = labor cost
rk = opportunity cost of capital
Chapter 8

56. Long-run Competitive Equilibrium
Zero-Profit
A firm is earning a normal return on its investment
Doing as well as it could by investing its money elsewhere
Normal return is firm’s opportunity cost of using money to buy capital instead of investing elsewhere
Competitive market long run equilibrium
Chapter 8 88

57. Long-run Competitive Equilibrium
Zero Economic Profits
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

58. 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.
This continues until there are no more profits to be gained in the market – zero economic profits
Chapter 8 89

59. Long-Run Competitive Equilibrium – Profits
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
$30 Q2 P2 q2
Output
Output
Chapter 8

60. Long-Run Competitive Equilibrium – Losses
Losses cause firms to leave
Supply decreases until profit = 0
$ per
unit of
output
Firm
$ per
unit of
output
Industry
LAC
LMC S2 D
$30 P2 Q2 q2 S1
$20 Q1 P1
Output
Output
Chapter 8

61. Long-Run Competitive Equilibrium
All firms in industry are maximizing profits
MR = MC
No firm has incentive to enter or exit industry
Earning zero economic profits
Market is in equilibrium
QD = QD
Chapter 8 93

62. Choosing Output in the Long Run
Economic Rent
The difference between what firms are willing to pay for an input less the minimum amount necessary to obtain it.
When some have accounting profits are larger than others, still earn zero economic profits because of the willingness of other firms to use the factors of production that are in limited supply
Chapter 8 95

63. Choosing Output in the Long Run
An Example
Two firms A & B that 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 = economic rent
Although economic rent has increased, economic profit has become zero
Chapter 8 95

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

65. Firms Earn Zero Profit in Long-Run Equilibrium
Ticket
Price
Economic Rent
LAC
LMC
$10
1.3
$7.20
A team with the same
cost in a larger city
sells tickets for $10.
Season Tickets
Sales (millions)
Chapter 8 97

66. 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

67. 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

68. 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 of inputs.
Chapter 8
101

69. The Industry’s Long-Run Supply Curve
Assume
All firms have access to the available production technology
Output is increased by using more inputs, not by invention
The market for inputs does not change with expansions and contractions of the industry.
Chapter 8
100

70. The Industry’s Long-Run Supply Curve
To analyze long-run industry supply, will need to distinguish between three different types of industries
Constant-Cost
Increasing-Cost
Decreasing-Cost
Chapter 8

71. Constant-Cost Industry
Industry whose long-run supply curve is horizontal
Assume a firm is initially in equilibrium
Demand increases causing price to increase
Individual firms increase supply
Causes firms to earn positive profits in short-run
Supply increases causing market price to decrease
Long run equilibrium – zero economic profits
Chapter 8

72. Constant-Cost Industry
Increase in demand increases market price and firm output
Positive profits cause market supply to increase and price to fall
Q1 increases to Q2.
Long-run supply = SL = LRAC.
Change in output has no impact on
input cost. $ $ S1 S2 AC MC D2 P2 q2 P2 D1 SL P1 P1 q1 Q1 Q2
Output
Output
Chapter 8

73. Long-Run Supply in a Constant-Cost Industry
Price of inputs does not change
Firms cost curves do not change
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

74. Increasing-Cost Industry
Prices of some or all inputs rises as production is expanded when demand of inputs increases
When demand increases causing prices to increase and production to increase
Firms enter the market increasing demand for inputs
Costs increase causing an upward shift in supply curves
Market supply increases but not as much
Chapter 8

75. Long-run Supply in an Increasing-Cost Industry
Due to the increase in input prices, long-run equilibrium occurs at a higher price.
Long Run Supply is upward Sloping $
SMC2
LAC2 $
SMC1
LAC1 S1 S2 SL D1 D2 q2 P2 P2 Q2 P3 P3 Q3 P1 P1 Q1 q1
Output
Output
Chapter 8

76. Long-Run Supply in a Increasing-Cost Industry
In a increasing-cost industry, long-run supply curve is upward sloping.
More output is produced, but only at the higher price needed to compete for the increased input costs
Chapter 8
100

77. Decreasing-Cost Industry
Industry whose long-run supply curve is downward sloping
Increase in demand causes production to increase
Increase in size allows firm to take advantage of size to get inputs cheaper
Increased production may lead to better efficiencies or quantity discounts
Costs shift down and market price falls
Chapter 8

78. Long-run Supply in a Decreasing-Cost Industry
Due to the decrease
in input prices, long-run
equilibrium occurs at
a lower price.
Long Run Supply is Downward Sloping $ $ S1 S2
SMC1
LAC1
SMC2
LAC2 D1 D2 q2 P2 Q2 P2 P1 SL P1 Q1 q1 P3 P3 Q3
Output
Output
Chapter 8

79. 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

80. Effect of an Output Tax on a Competitive Firm’s Output
The firm will
reduce output to
the point at which
the marginal cost
plus the tax equals
the price. q2
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.
AVC1
MC1 P1 q1
Output
Chapter 8
121

81. 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

82. Long-Run Elasticity of Supply
Constant-cost industry
Long-run supply is horizontal
Small increase in price will induce an extremely large output increase
Long-run supply elasticity is infinitely large
Inputs would be readily available
Chapter 8
130

83. Long-Run Elasticity of Supply
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