1. Chapter 8 Profit Maximization and Competitive Supply

2. Chapter 8Slide 2 Topics to be Discussed Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run

3. Chapter 8Slide 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

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

5. Chapter 8Slide 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.

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

7. Chapter 8Slide 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.

8. Chapter 8Slide 8 Profit Maximization Do firms maximize profits? Possibility of other objectives  Revenue maximization  Dividend maximization

9. Chapter 8Slide 9 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 and does not exclude the possibility of altruistic behavior.

10. Chapter 8Slide 10 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:

11. Chapter 8Slide 11 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. Marginal Revenue, Marginal Cost, and Profit Maximization

12. Chapter 8Slide 12 Comparing R(q) and C(q) Output levels: 0- q 0 :  C(q)> R(q) Negative profit  FC + VC > R(q)  MR > MC Indicates higher profit at higher output 0 Cost, Revenue, Profit ($s per year) Output (units per year) R(q) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost, and Profit Maximization

13. Chapter 8Slide 13 Comparing R(q) and C(q) Question: Why is profit negative when output is zero? Marginal Revenue, Marginal Cost, and Profit Maximization R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q*

14. Chapter 8Slide 14 Comparing R(q) and C(q) Output levels: q 0 - q *  R(q)> C(q)  MR > MC Indicates higher profit at higher output Profit is increasing R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost, and Profit Maximization

15. Chapter 8Slide 15 Comparing R(q) and C(q) Output level: q *  MR = MC  Profit is maximized R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost, and Profit Maximization

16. Chapter 8Slide 16 Comparing R(q) and C(q) Output levels beyond q * :  MC > MR  Profit is decreasing Marginal Revenue, Marginal Cost, and Profit Maximization R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q*

17. Chapter 8Slide 17 Marginal Revenue, Marginal Cost, and Profit Maximization

18. Chapter 8Slide 18 Marginal Revenue, Marginal Cost, and Profit Maximization

19. Chapter 8Slide 19 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 Marginal Revenue, Marginal Cost, and Profit Maximization

20. Demand and Marginal Revenue Faced by a Competitive Firm Output (bushels) Price $ per bushel Price $ per bushel Output (millions of bushels) d$4 100200100 FirmIndustry D $4

21. Chapter 8Slide 21 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. Marginal Revenue, Marginal Cost, and Profit Maximization

22. Chapter 8Slide 22 The Competitive Firm AR = MR = P Profit Maximization  MC(q) = MR = P Marginal Revenue, Marginal Cost, and Profit Maximization

23. Chapter 8Slide 23 Choosing Output in the Short Run We will combine production and cost analysis with demand to determine output and profitability.

24. Chapter 8Slide 24 q0q0 Lost profit for q 1 < q * Lost profit for q 2 > q * q1q1 q2q2 A Competitive Firm Making a Positive Profit 10 20 30 40 Price ($ per unit) 01234567891011 50 60 MC AVC ATC AR=MR=P Output q*q* At q * : MR = MC and P > ATC D A B C q 1 : MR > MC and q 2 : MC > MR and q*: MC = MR but MC falling

25. Chapter 8Slide 25 Would this producer continue to produce with a loss? A Competitive Firm Incurring Losses Price ($ per unit) Output AVC ATC MC q*q* P = MR B F C A E D At q * : MR = MC and P < ATC Losses = (P- ATC) x q * or ABCD

26. Chapter 8Slide 26 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 produces at a loss. If P < AVC < ATC the firm should shut- down.

27. Chapter 8Slide 27 A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) Output MC AVC ATC P = AVC What happens if P < AVC? P2P2 q2q2 P1P1 q1q1 The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production.

28. Chapter 8Slide 28 Observations: P = MR MR = MC P = MC Supply is the amount of output for every possible price. Therefore: If P = P 1, then q = q 1 If P = P 2, then q = q 2 A Competitive Firm’s Short-Run Supply Curve

29. Chapter 8Slide 29 Price ($ per unit) MC Output AVC ATC P = AVC P1P1 P2P2 q1q1 q2q2 S = MC above AVC A Competitive Firm’s Short-Run Supply Curve Shut-down

30. Chapter 8Slide 30 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. A Competitive Firm’s Short-Run Supply Curve

31. Chapter 8Slide 31 Firm’s Response to an Input Price Change When the price of a firm’s input changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. A Competitive Firm’s Short-Run Supply Curve

32. Chapter 8Slide 32 MC 2 q2q2 Input cost increases and MC shifts to MC 2 and q falls to q 2. MC 1 q1q1 The Response of a Firm to a Change in Input Price Price ($ per unit) Output $5 Savings to the firm from reducing output

33. Chapter 8Slide 33 MC 3 Industry Supply in the Short Run $ per unit 024810571521 MC 1 S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. Quantity MC 2 P1P1 P3P3 P2P2

34. Chapter 8Slide 34 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. The Short-Run Market Supply Curve

35. Chapter 8Slide 35 A D B CProducerSurplus Alternatively, VC is the sum of MC or ODCq *. R is P x q * or OABq *. Producer surplus = R - VC or ABCD. Producer Surplus for a Firm Price ($ per unit of output) OutputAVCMC0 P q*q*q*q* At q * MC = MR. Between 0 and q, MR > MC for all units.

36. Chapter 8Slide 36 Producer Surplus in the Short-Run Profit = R - VC - FC Profit < producer surplus The Short-Run Market Supply Curve

37. Chapter 8Slide 37 D P*P*P*P* Q*Q*Q*Q* ProducerSurplus Market producer surplus is the difference between P* and S from 0 to Q *. Producer Surplus for a Market Price ($ per unit of output) OutputS

38. Chapter 8Slide 38 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.

39. Chapter 8Slide 39 q1q1 A B C D In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. Output Choice in the Long Run Price ($ per unit of output) Output P = MR $40 SAC SMC In the long run, the plant size will be increased and output increased to q 3. Long-run profit, EFGD > short run profit ABCD. q3q3 q2q2 G F $30 LAC E LMC

40. Chapter 8Slide 40 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

41. Chapter 8Slide 41 Choosing Output in the Long Run 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 Long-Run Competitive Equilibrium

42. Chapter 8Slide 42 Choosing Output in the Long Run Entry and Exit The long-run response to short-run profits is to increase output. Profits will attract other producers. More producers increase industry supply which lowers the market price. Long-Run Competitive Equilibrium

43. S1S1 Output $ per unit of output $ per unit of output $40 LAC LMC D S2S2 P1P1 Q1Q1 q2q2 FirmIndustry $30 Q2Q2 P2P2 Profit attracts firms Supply increases until profit = 0

44. Chapter 8Slide 44 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

45. A P1P1 AC P1P1 MC q1q1 D1D1 S1S1 Q1Q1 C D2D2 P2P2 P2P2 q2q2 B S2S2 Q2Q2 Economic profits attract new firms. Supply increases to S 2 and the market returns to long-run equilibrium. Long-Run Supply in a Constant-Cost Industry Output $ per unit of output $ per unit of output SLSL Q 1 increase to Q 2. Long-run supply = S L = LRAC. Change in output has no impact on input cost.

46. Chapter 8Slide 46 In a constant-cost industry, long-run supply is a horizontal line Long-Run Supply in a Constant-Cost Industry

47. Long-Run Supply in an Increasing-Cost Industry Output $ per unit of output $ per unit of output S1S1 D1D1 P1P1 AC 1 P1P1 MC 1 q1q1 Q1Q1 A SLSLSLSL P3P3 MC 2 Due to the increase in input prices, long-run equilibrium occurs at a higher price. AC 2 B S2S2 P3P3 Q3Q3 q2q2 P2P2 P2P2 D2D2 Q2Q2

48. Chapter 8Slide 48 In a increasing-cost industry, long-run supply curve is upward sloping. Long-Run Supply in a Increasing-Cost Industry

49. S2S2 B SLSL P3P3 Q3Q3 MC 2 P3P3 AC 2 Due to the decrease in input prices, long-run equilibrium occurs at a lower price. Long-Run Supply in an Decreasing-Cost Industry Output $ per unit of output $ per unit of output P1P1 P1P1 MC 1 A D1D1 S1S1 Q1Q1 q1q1 AC 1 Q2Q2 q2q2 P2P2 P2P2 D2D2

50. Chapter 8Slide 50 In a decreasing-cost industry, long-run supply curve is downward sloping. Long-Run Supply in a Increasing-Cost Industry

51. Chapter 8Slide 51 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. The Industry’s Long-Run Supply Curve

52. Chapter 8Slide 52 Effect of an Output Tax on a Competitive Firm’s Output Price ($ per unit of output) Output AVC 1 MC 1 P1P1 q1q1 The firm will reduce output to the point at which the marginal cost plus the tax equals the price. q2q2 t MC 2 = MC 1 + tax AVC 2 An output tax raises the firm’s marginal cost by the amount of the tax.

53. Chapter 8Slide 53 Effect of an Output Tax on Industry Output Price ($ per unit of output) Output D P1P1 SS1SS1 Q1Q1 P2P2 Q2Q2 S S 2 = S 1 + t t Tax shifts S 1 to S 2 and output falls to Q 2. Price increases to P 2.

54. Chapter 8Slide 54 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.

55. Chapter 8Slide 55 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.

56. Chapter 8Slide 56 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.

57. Chapter 8Slide 57 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.

58. End of Chapter 8