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 Perfectly Competitive Markets Discussion Questions What are some barriers to entry and exit? Are all markets competitive? When is a market highly competitive?

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

10. Chapter 8Slide 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

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

12. Chapter 8Slide 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:

13. Chapter 8Slide 13 Profit Maximization in the Short Run 0 Cost, Revenue, Profit ($s per year) Output (units per year) R(q) Total Revenue Slope of R(q) = MR

14. Chapter 8Slide 14 0 Cost, Revenue, Profit $ (per year) Output (units per year) Profit Maximization in the Short Run C(q) Total Cost Slope of C(q) = MC Why is cost positive when q is zero?

15. Chapter 8Slide 15 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

16. Chapter 8Slide 16 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

17. Chapter 8Slide 17 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*

18. Chapter 8Slide 18 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

19. Chapter 8Slide 19 Comparing R(q) and C(q) Output level: q *  R(q)= C(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

20. Chapter 8Slide 20 Question Why is profit reduced when producing more or less than q*? 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

21. Chapter 8Slide 21 Comparing R(q) and C(q) Output levels beyond q * :  R(q)> C(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*

22. Chapter 8Slide 22 Therefore, it can be said: Profits are maximized when MC = MR. 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*

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

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

25. Chapter 8Slide 25 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

26. 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

27. Chapter 8Slide 27 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

28. Chapter 8Slide 28 The Competitive Firm The competitive firm’s demand  If the producers tries to lower price he cannot increase sales  P = D = MR = AR Marginal Revenue, Marginal Cost, and Profit Maximization

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

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

31. Chapter 8Slide 31 q0q0 Lost profit for q q < 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 0 : MC = MR but MC falling

32. Chapter 8Slide 32 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- AC) x q * or ABCD

33. Chapter 8Slide 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.

34. Chapter 8Slide 34 The Short-Run Output of an Aluminum Smelting Plant Output (tons per day) Cost (dollars per item) 3006009000 1100 1200 1300 1400 1140 P1P1 P2P2 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?

35. Chapter 8Slide 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.

36. Chapter 8Slide 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.

37. Chapter 8Slide 37 Three guidelines for estimating marginal cost: 3)All opportunity cost should be included in determining marginal cost. Some Cost Considerations for Managers

38. Chapter 8Slide 38 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.

39. Chapter 8Slide 39 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

40. Chapter 8Slide 40 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

41. Chapter 8Slide 41 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

42. Chapter 8Slide 42 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. A Competitive Firm’s Short-Run Supply Curve

43. Chapter 8Slide 43 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

44. Chapter 8Slide 44 The Short-Run Production of Petroleum Products Cost ($ per barrel) Output (barrels/day) 8,0009,00010,00011,000 23 24 25 26 27 SMC 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.

45. Chapter 8Slide 45 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. The Short-Run Production of Petroleum Products

46. Chapter 8Slide 46 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: The Short-Run Production of Petroleum Products

47. Chapter 8Slide 47 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 Question: If increasing output raises input costs, what impact would it have on market supply?

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

49. Chapter 8Slide 49 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. The Short-Run Market Supply Curve

50. Chapter 8Slide 50 Questions 1)Give an example of a perfectly inelastic supply. 2)If MC rises rapidly, would the supply be more or less elastic? The Short-Run Market Supply Curve

51. Chapter 8Slide 51 The World Copper Industry (1999) Annual ProductionMarginal Cost Country(thousand metric tons)(dollars/pound) Australia6000.65 Canada7100.75 Chile36600.50 Indonesia7500.55 Peru4500.70 Poland4200.80 Russia4500.50 United States18500.70 Zambia2800.55

52. Chapter 8Slide 52 The Short-Run World Supply of Copper Production (thousand metric tons) Price ($ per pound) 0200040006000800010000 0.40 0.50 0.60 0.70 0.80 0.90 MC C,MC R MC J,MC Z MC A MC P,MC US MC Ca MC Po

53. Chapter 8Slide 53 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

54. Chapter 8Slide 54 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.

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

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

57. Chapter 8Slide 57 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

58. Chapter 8Slide 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.

59. Chapter 8Slide 59 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

60. Chapter 8Slide 60 q1q1 A B C D Output Choice in the Long Run Price ($ per unit of output) Output P = MR $40 SAC SMC Question: Is the producer making a profit after increased output lowers the price to $30? q3q3 q2q2 G F $30 LAC E LMC

61. Chapter 8Slide 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

62. Chapter 8Slide 62 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

63. Chapter 8Slide 63 Choosing Output in the Long Run 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. Long-Run Competitive Equilibrium

64. 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

65. Chapter 8Slide 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

66. Chapter 8Slide 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?

67. Chapter 8Slide 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.

68. Chapter 8Slide 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

69. Chapter 8Slide 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

70. Chapter 8Slide 70 Firms Earn Zero Profit in Long-Run Equilibrium Ticket Price Season Tickets Sales (millions) LAC $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). LMC

71. Chapter 8Slide 71 1.3 $10 Economic Rent Ticket Price $7 LAC A team with the same cost in a larger city sells tickets for $10. Firms Earn Zero Profit in Long-Run Equilibrium Season Tickets Sales (millions) LMC

72. Chapter 8Slide 72 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. Firms Earn Zero Profit in Long-Run Equilibrium

73. Chapter 8Slide 73 If the opportunity cost of the input (rent) is not taken into consideration it may appear that economic profits exist in the long-run. Firms Earn Zero Profit in Long-Run Equilibrium

74. Chapter 8Slide 74 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. The Industry’s Long-Run Supply Curve

75. Chapter 8Slide 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.

76. Chapter 8Slide 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.

77. 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.

78. Chapter 8Slide 78 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. Long-Run Supply in a Constant-Cost Industry

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

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

81. Chapter 8Slide 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 S L in a decreasing-cost industry?

82. S2S2 B SLSL P3P3 Q3Q3 SMC 2 P3P3 LAC 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 SMC 1 A D1D1 S1S1 Q1Q1 q1q1 LAC 1 Q2Q2 q2q2 P2P2 P2P2 D2D2

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

84. Chapter 8Slide 84 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

85. Chapter 8Slide 85 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.

86. Chapter 8Slide 86 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.

87. Chapter 8Slide 87 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 The Industry’s Long-Run Supply Curve

88. Chapter 8Slide 88 Long-Run Elasticity of Supply 1)Constant-cost industry  Long-run supply elasticity is infinitely large  Inputs would be readily available The Industry’s Long-Run Supply Curve

89. Chapter 8Slide 89 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 The Industry’s Long-Run Supply Curve

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

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

92. Chapter 8Slide 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?

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

94. Chapter 8Slide 94 Questions Is this an increasing or a constant-cost industry? What would you predict about the elasticity of supply? The Long-Run Supply of Housing

95. Chapter 8Slide 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.

96. Chapter 8Slide 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.

97. Chapter 8Slide 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.

98. Chapter 8Slide 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.

99. End of Chapter 8 Profit Maximization and Competitive Supply