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
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
No rule of thumb to determine whether a market is close to perfectly competitive
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)
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
Slope of total cost curve is marginal cost
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
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
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 Why would firm produce at a loss?
Might think price will increase in near future
Shutting down and starting up could be costly
Firm has two choices in short run
Continue producing
Shut down temporarily
Will compare profitability of both choices
Chapter 8

30. Short Run Production When should the firm shut down?
If AVC < P < ATC, the firm should continue producing in the short run
If AVC > P, the firm should shut-down.
Can not cover even its fixed costs
Chapter 8

31. 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

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. 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

35. 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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. Choosing Output in the Long Run
In short run, one or more inputs are fixed
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

47. Choosing Output in the Long Run
In the short run a firm faces a horizontal demand curve
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

48. 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

49. 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

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

51. 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

52. 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

53. 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

54. 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

55. 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

56. 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

57. 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

58. 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