1. Profit Maximization and the Decision to Supply

2. Market Structure Firms are assumed to maximize economic profits
Economic Profit = Revenue – Total Opportunity Costs
Costs are dependent on technology and input prices
Revenue is dependent upon the market structure in which a firm operates
Therefore, the profit maximization decision must be analyzed by market structure

3. Market Structures Competitive Markets Monopoly Oligopoly
Monopolistic Competition

4. Quick Overview
Marginal benefits from a firms perspective are marginal revenue from selling output
Marginal revenue equal the extra revenue from selling another unit of output
Assuming the firm produces (does not shutdown), the firm will maximize profit (or minimize losses) where MR=MC

5. Marginal Revenue and Market Structure
Competitive markets – sellers are price takers so MR = Market Price
Monopoly – the seller is a price maker and faces the entire market demand curve so MR < Price
Oligopoly – the seller directly competes with a few firms so MR depends on the actions of competitors
Monopolistic Competition – sellers possess some market power and can set their own prices in the short-run, so MR<P

6. Competitive Markets or Pure Competition
Assumptions revisited
Many buyers and sellers
Each buyer and seller is a price taker
Homogenous or identical products
Competition is based only on the price
Perfect information or knowledge
All firms have access to the same technology
Competition is based upon price
Firms can freely enter or exit
Profits will be eliminated in the long-run

7. Revenue in Competitive Markets
The market demand and supply curves determine the equilibrium price and quantity and the price that buyers will pay and sellers receive
As with producer surplus, sellers are price takers and the price they receive is their MR. The marginal revenue and the price remain the same no matter how much output is sold.

8. Table 1 Total, Average, and Marginal Revenue for a Competitive Firm
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9. Competitive Firm in the Short-run
Short-run – at least one fixed factor = fixed costs. Assume the plant size is fixed.
Set MR=MC to find profit maximizing level of output. Use the average cost curves to determine whether one
Operates and earn profits
Operate and breakeven
Operates and make losses
Shutdowns and minimize losses

10. Table 2 Profit Maximization: A Numerical Example
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11. Figure 1 Profit Maximization for a Competitive Firm
Costs
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
and
Revenue MC MC 2 Q
ATC P = MR 1 2 AR Q
MAX
AVC MC 1 Q
Quantity
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12. Conditions for Profits, Breakeven, Losses and Shutdown
P > ATC
Breakeven
P = ATC
Losses but operate
P > AVC but P < ATC or
ATC > P > AVC
Shutdown
P < AVC

13. Figure 5 Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits
Price
ATC MC
Profit
ATC Q P P = AR MR
Quantity
(profit-maximizing quantity)
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14. Figure 5 Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses
Price MC
ATC
ATC Q
Loss P = AR MR
Quantity
(loss-minimizing quantity)
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15. Short-run Supply
Individual Firm: The short-run supply curve is MC curve above minimum AVC.
Market: The short-run supply curve is the horizontal sum of all of the individual firm’s MC curves above the minimum AVC.

16. Figure 3 The Competitive Firm’s Short Run Supply Curve
Costs
Firm ’
s short-run
supply curve
If P > ATC, the firm will continue to produce at a profit. MC
ATC
If P > AVC, firm will continue to produce in the short run.
AVC
Firm
shuts
down if P
<
AVC
Quantity
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17. Figure 6 Market Supply with a Fixed Number of Firms
Assume 100 firms with identical plant sizes and horizontally sum their marginal cost curves above minimum AVC
(a) Individual Firm Supply
(b) Market Supply
Price
Price MC
Supply
$2.00
200
$2.00
200,000
1.00
100
1.00
100,000
Quantity (firm)
Quantity (market)
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18. Price Determination in the Short-run
Fixed plant sizes implies a fixed number of firms.
Market supply and demand curve determine the price and the profit loss situations of existing firms.
If demand increase, firms increase the quantity supplied by utilizing increasing capacity.
The law of diminishing returns implies that supply is upward sloping at that prices will rise.

19. Long-run Supply and Price Determination
Long-run – all factors are variable = no fixed costs and plant size can be changed, ALSO firms can enter and exit
If economic profits are positive, new firms will enter.
If economic profits are negative, existing firms will exit.
Long-run equilibrium:
Firms must chose the plant that minimizes LRATC or they will suffer losses.
Economic profits are reduced to zero.

20. Figure 7 Market Supply with Entry and Exit
(a) Firm ’
s Zero-Profit Condition
(b) Market Supply
Price
Price
LRMC MC
LRATC
ATC P
= minimum
ATC
Supply
Quantity (firm)
Quantity (market)
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21. Figure 8 An Increase in Demand in the Short Run and Long Run
(a) Initial Condition
Firm
Market
Price
Price
ATC MC S
Short-run supply, 1 D
Demand, 1 1 Q A P 1
Long-run
supply P 1
Quantity (firm)
Quantity (market)

22. Figure 8 An Increase in Demand in the Short Run and Long Run
(c) Long-Run Response
Firm
Market
Price
Price D 2 S MC
ATC 1 S 2 B P 2 A Q 3 C P 1 P
Long-run 1
supply D 1
Quantity (firm) Q Q
Quantity (market) 1 2
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23. Long-run Supply Curve
Constant cost industries – horizontal or perfectly elastic supply
Increasing cost industries – upward sloping supply
Some resource may be available in limited quantities (farm land)
Some resources may increase in cost or be less productive (skilled labor)
Decreasing cost industries – downward sloping supply
Increased output may stimulate increased productivity or technological change (computers)

24. Competitive Markets: Short-run and Long-run
Short-run supply response to changes in demand are to increase or decrease the use of existing capacity.
Long-run supply response is to build efficient plant size and increase or decrease capacity.
In both the short-run and long-run, the profit maximizing behavior of firms leads to supply responses to accommodate changes in demand.
In the short-run, prices act as signals and, in the long-run,prices and profits act as signals to increase or decrease output.

25. Efficiency Revisited
Maximize human satisfaction from resources = maximize total surplus = maximize consumer surplus + producer surplus.
Two conditions:
Produce what is most highly valued and the amount that maximizes total surplus
Produce it at the least possible cost.

26. In the absence of market failures, competitive markets are efficient in both the short-run and the long-run:
Supply responds to what consumers demand
Goods are produced at least possible cost
Price and profits are extremely important as signals for the allocation of scarce resources.
Examples of when prices and profits no longer act as signal are rent controls and price supports