chapter 8 profit maximization and competitive supply

Cost, Revenue, Profit $s per yearOutput units per year Rq Cq A Marginal Revenue, Marginal Cost, and Profit Maximization... Marginal Revenue, Marginal Cost, and Profit Maximization Rq 0 C

Chapter 8

Profit Maximization and Competitive

Supply

Topics to be Discussed

Supply Curve

Perfectly Competitive Markets

Markets1) Price taking2) Product homogeneity3) Free entry and exit

Perfectly Competitive Markets

 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.

Perfectly Competitive Markets

Perfectly Competitive Markets

 Buyers can easily switch from one supplier

to another.

 Suppliers can easily enter or exit a market.

Profit Maximization

 Possibility of other objectives

 Revenue maximization

 Dividend maximization

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.

Marginal Revenue, Marginal Cost,

and Profit Maximization

) (

)

π

 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

Cost, Revenue, Profit ($s per year)

Output (units per year)

R(q)

C(q) A

Marginal Revenue, Marginal Cost,

and Profit Maximization

 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

 Profit is increasing

R(q)

0

Cost, Revenue, Profit

$ (per year)

Output (units per year)

C(q) A

Marginal Revenue, Marginal Cost,

and Profit Maximization

$ (per year)

Output (units per year)

C(q) A

Marginal Revenue, Marginal Cost,

and Profit Maximization

 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

- R

=

π

Marginal Revenue, Marginal Cost,

and Profit Maximization

q

R MR

∆

∆

=

or q

C q

R

0 q

: when maximized

are Profits

Marginal Revenue, Marginal Cost,

and Profit Maximization

 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

Demand and Marginal Revenue Faced

by a Competitive Firm

Output (bushels)

Output (millions

 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

 The Competitive Firm

 AR = MR = P

 Profit Maximization

MC(q) = MR = P

Marginal Revenue, Marginal Cost,

and Profit Maximization

Choosing Output in the Short Run

analysis with demand to determine output and profitability

q *

At q * : MR = MC and P > ATC

ABCD or

q

x ATC) -

Would this producer continue to produce with a loss?

A Competitive Firm

Incurring Losses

Price ($ per unit)

Output

AVC

ATC MC

q *

P = MR B

Choosing Output in the Short Run

 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.

A Competitive Firm’s

Short-Run Supply Curve

Price ($ per unit)

Output

MC

AVC ATC

P = AVC What happens if P < AVC?

Price ($ per unit)

MC

Output

AVC ATC

A Competitive Firm’s

Short-Run Supply Curve

 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

MC 2

q 2

Input cost increases

and MC shifts to MC 2 and q falls to q 2 .

MC 1

q 1

The Response of a Firm to

a Change in Input Price

Price ($ per unit)

Output

$5

Savings to the firm from reducing output

MC 3

Industry Supply in the Short Run

$ per unit

MC 1 industry supply curve The short-run S

is the horizontal summation of the supply curves of the firms.

 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

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)

Output

AVC MC

 Producer Surplus in the Short-Run

The Short-Run Market Supply Curve

VC -

R PS

Surplus

P *

Q *

Producer Surplus

Market producer surplus is

the difference between P* and S from 0 to Q *

Producer Surplus for a Market

Price ($ per

unit of

output)

Output

S

Choosing Output in the Long Run

inputs, including the size of the plant

q 1

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

In the long run, the plant size will be

increased and output increased to q 3 .

Long-run profit, EFGD > short run

Choosing Output in the Long Run

Choosing Output in the Long Run

 Zero-Profit

the firms is earning a normal rate of return; indicating the industry is competitive

business

Long-Run Competitive Equilibrium

Choosing Output in the Long Run

 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

S 1

Long-Run Competitive Equilibrium

$ per unit of output

D

S 2

P 1

Q q

$30

Q

P 2

•Profit attracts firms

•Supply increases until profit = 0

Choosing Output in the Long Run

 Long-Run Competitive Equilibrium

1) MC = MR 2) P = LAC

3) Equilibrium Market Price

P 1

AC

P 1 MC

Economic profits attract new

firms Supply increases to S 2 and the market returns to long-run

 In a constant-cost industry, long-run supply is a horizontal line

Long-Run Supply in a

Constant-Cost Industry

Long-Run Supply in an

Increasing-Cost Industry

$ per unit of output

Due to the increase

in input prices, long-run equilibrium occurs at

 In a increasing-cost industry, long-run supply curve is upward sloping.

Long-Run Supply in a

Increasing-Cost Industry

Due to the decrease

in input prices, long-run equilibrium occurs at

 In a decreasing-cost industry, long-run supply curve is downward sloping.

Long-Run Supply in a

Increasing-Cost Industry

 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

Effect of an Output Tax on a

Competitive Firm’s Output

Price ($ per unit of output)

Effect of an Output

Tax on Industry Output

Price ($ per unit of output)

Tax shifts S 1 to S 2 and

output falls to Q 2 Price

increases to P 2 .

accordance with a complex set of objectives and under various

constraints

choice under the assumption that the demand for its own output is horizontal

maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost

the horizontal summation of the supply curves of the firms in an industry

difference between revenue of a firm and the minimum cost that would be necessary to produce the profit-

maximizing output

competitive firms choose the output at which price is equal to long-run

marginal cost

be horizontal, upward sloping, or downward sloping

End of Chapter 8